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Investing in Infrastructure - International Best Legal Practice in Project and Construction Agreements - 2016

www.pwc.com.au Investing in Infrastructure | International Best Legal Practice in Project and Construction Agreements | January 2016 Damian McNair | Partner, Legal | M: +61 421 899 231 | E: damian.mcnair@au.pwc.com Investing in Infrastructure International Best Legal Practice in Project and Construction Agreements – 2016 PwC i Introduction The increasing role of superannuation funds in infrastructure investment has been well documented. Governments are encouraging further involvement in infrastructure investment from superannuation funds, primarily to assist in closing Australia’s infrastructure gap, which is currently growing at an estimated rate of $20 billion per year. However, investment activity has been impacted by the perceived risks in greenfield infrastructure investment. The identification, allocation and management of risks are matters that superannuation funds must address if they are to participate successfully in infrastructure investment during the implementation and delivery phases of greenfield projects. This Best Practice Guide aims to provide some guidance to superannuation funds in identifying, allocating and managing those risks, from both a legal and commercial perspective. This Best Practice Guide is also a useful tool for experienced infrastructure funds, governments, Developers and Lenders investing in infrastructure. It contains detailed position papers on greenfield risks relating to time, cost and, in our view, the critical risk in any project – underperformance. It also contains corresponding papers on liability issues. All of these will enable you to better understand the risk exposures when investing in greenfield infrastructure projects and evaluating latent risk in brownfield infrastructure projects. The current outlook on infrastructure investment As of January 2014, approximately 5% of the portfolios of Australian superannuation funds were committed to infrastructure, including both equity and debt investment. This figure is recognised as one of the largest by volume of any pension system in the world and policymakers and stakeholders in the superannuation industry are also seeking to promote and encourage further investment growth in infrastructure. The Federal Government has been vocal in seeking to introduce reforms to encourage private involvement in infrastructure, with former Treasurer Joe Hockey previously stating that the Federal Government was prepared to consider a range of options to increase incentives to invest. The Opposition has announced its intention to introduce a policy to create an “infrastructure market” driven by investment by superannuation funds. And current Treasurer Scott Morrison has indicated that the Government may be willing to agree to such a policy. ANZ chief executive and Australian B20 leader Mike Smith has also outlined the B20’s policy of promoting private sector investment and said that infrastructure was a “natural asset class for pension funds”. Despite these acknowledgements, growth in infrastructure investment by superannuation funds has been slow, particularly in greenfield projects. Recent major superannuation led transactions have generally been restricted to brownfield investment as most funds confine their interest to brownfield projects, where there is an intermediate return for their investors. For example, the consortium led by Industry Funds Management in Port Botany and Port Kembla in 2013 and the 2014 multi-party bid process in relation to the QML assets. This may be changing, particularly with the free trade agreement signed on April 9, 2014 between Australia and Korea. Korean investors, such as National Pension Fund, Korean Investment Corporation and Samsung Life Insurance, are targeting investment in Australian projects in resources and infrastructure by following Korean equity and construction integrated heavyweights such as POSCO, Samsung and Hyundai. Notwithstanding that, it is apparent that the unique and additional risks present in greenfield projects are preventing growth, despite the benefits and potentially more significant returns that greenfield investment can provide. This Best Practice Guide has been formulated with those risks in mind, using PwC’s expertise and experience in project and construction contracting to assist funds in managing greenfield investment risk. Our expertise in risk identification, allocation and management across a range of sectors is essential for superannuation funds seeking to increase their commitment and investment in greenfield infrastructure. Introduction PwC ii Understanding current concerns of funds In understanding the application of the appropriate risk identification, allocation and management tools, one should have in mind the specific challenges superannuation funds face as investors. Factors acknowledged by industry bodies as having a negative effect on greenfield investment include:  Lack of construction expertise: Superannuation funds may not all be well placed to assess an infrastructure asset as an investment opportunity. While funds have access to a wide range of information and expertise in regard to traditional investments such as equities, some do not have the benefit of the resources and experience required to obtain and analyse information needed to assess infrastructure projects, particularly during the most high risk phase, the construction period  Fund size: The superannuation fund market is highly fragmented, meaning that smaller funds may lack the capital to become involved in infrastructure. A number of recent mergers and growth in the sector have led to the development of some larger funds. However, the increase in use of the self-managed super fund model by individuals is offsetting that consolidation  Liquidity: Under current choice of fund legislation, superannuation funds are obligated to transfer a member’s funds within 30 days of a request for transfer. Consequently, they must retain a certain level of liquidity in their investments in order to meet that regulatory burden. The illiquid nature of infrastructure investment means that funds face compliance issues when directly investing in infrastructure  Low risk appetite: Fund trustees owe their primary duties and obligations to their members, who are generally seeking steady positive returns from their fund. As such, funds will naturally prefer to limit their downside risks. This sits uncomfortably with equity investment in infrastructure, particularly in greenfields projects, where there may be a substantial delay in earning returns and the burden of construction risks  Limited pipeline of opportunities: Funds have also been critical of a lack of viable investment options currently available across infrastructure sectors in Australia. It is generally accepted that there are too few projects currently in the infrastructure pipeline which satisfy the preferences of superannuation funds as investors  Procurement costs: The time and monetary costs of the bidding process are often cited by superannuation funds as prohibitive, particularly given the cost of a losing bid needs to be covered  Tightened regulatory framework: In 2013 the MySuper legislative reforms were introduced, with the aim of providing a default, ‘plain vanilla’ option for all super fund investors. While these reforms bring consumer protection benefits, they restrict the choices a trustee can make in taking on riskier investments and further increase liquidity pressures, providing a disincentive to invest in riskier infrastructure investments  Unfavourable banking terms and underdeveloped debt markets: Current market practice shows that Australian banks are very hesitant to extend debt terms beyond 10 years. Australia’s corporate bond market is also underdeveloped, meaning that projects often have limited choice in terms of debt finance. This exposes superannuation funds to refinancing risks as equity investors. The lack of any large or active infrastructure bond market also means that superannuation funds do not often have an opportunity to make any indirect investment in infrastructure assets. Introduction PwC iii Risk identification, allocation and management tools in Greenfields projects Given the significant challenges outlined above, it is essential that superannuation funds are equipped with the tools and expertise to appropriately identify, allocate and manage design, construction, commissioning and operational risk in any future greenfield investment. Generally, only infrastructure projects undertaken within a stable regulatory framework, with low technology risk and with a sufficiently stable revenue stream are regarded as suitable investment targets for superannuation funds. The principles outlined in this Best Practice Guide can be utilised to examine the suitability of infrastructure projects for investment and to identify and allocate risks. These principles are also useful tools for experienced Developers and Lenders investing in infrastructure. In addition, a tailored contractual approach is desirable to manage risks in a greenfield infrastructure project and to also ensure a project is bankable. In assessing bankability, Lenders will look at a range of factors and assess the suite of project contracts, with particular attention on the construction arrangements, as a whole. Therefore, in isolation it is difficult to state whether one contracting approach is or is not bankable. However, generally speaking, the Lenders will require the following:  a fixed completion date  a fixed completion price  no or limited technology risk  output guarantees  liquidated damages for both delay and poor performance  security from the contract and/or its parent company  large caps on liability (ideally, there would be no caps on liability, however, given the nature of EPC contracting and the risks to the Contractors involved there are almost always caps on liability)  restrictions on the ability of the Contractor to claim extensions of time and additional costs. See Articles 5-10 for more information regarding contract delivery methods for various types of projects which can be translated into other sectors. Similarly, investors must also be aware of the operational risks present in a project. If the asset fails to generate revenue, then the investor’s return is at risk. The patronage risk present in many infrastructure projects has restricted super fund investment, particularly given the recent underperformance of a number of toll roads in Australia, eg Sydney’s Lane Cove Tunnel and Brisbane’s Rivercity Motorway. ANZ chief executive and Australian B20 leader Mike Smith has also recently emphasised the need for greater protections for superannuation fund investors at an infrastructure roundtable. Mr Smith stated that projects must be structured to “protect the income flows to [pension funds] so there is an incentive to invest.” In light of these concerns, best practice by investors will require a carefully designed contract package to ensure that appropriate safeguards for revenue are in place. Further guidelines on construction operation and offtaker contract protections are set out in the remainder of this Best Practice Guide. While this expertise can add the most value in a greenfield project, our best practice principles are also equally applicable to prospective purchases of existing infrastructure by superannuation funds and other investors, particularly where substantial capital expenditure may be required. Investors can utilise this expertise in order to manage ongoing constructional and operational risks and to undertake appropriate due diligence when purchasing an existing asset. Introduction PwC iv Trends in infrastructure investment PwC’s expertise and advice in this area is updated regularly, taking account of trends in government and global thinking on greenfield project risk management. Internationally, Canada has taken progressive steps in the area of pension fund investment in infrastructure, and is now seen as a potential role model for the systems of risk allocation and deal structuring in Australia. Large Canadian pension funds have a current allocation of 5.2% to infrastructure investment in their portfolios, of which 51% is direct investment in unlisted assets – the highest rate globally. Canadian funds are developing their own in house specialist infrastructure investment teams and are using past experiences to better assess and manage risk within transactions. This is seen as one of the key reasons that the rate of Canadian direct investment is at such a high level. Additional factors also assist Canadian funds in their investments, such as more flexible and long term debt arrangements, the existence of an established infrastructure bond market and the pooling of assets of smaller funds. This Canadian model of investment has shown that pension funds can engage in direct investment in infrastructure successfully, provided that the right expertise is provided in identifying investments and allocating and managing risks when investing in a project. In regard to operational risk, patronage risk sharing models are being trialled overseas, to better protect pension fund investors from the operating risks of a project. An example of this model was adopted by the International Project Finance Association in March 2013. The new transaction structure, called PEBBLE, is essentially aimed at separating the funding of the project into short term and long term categories of bonds. This structure aims to allow institutional investors to avoid exposure to potential short term downsides in exchange for a lower risk, long term return. Similar structures are likely to be utilised further as a means of addressing risk for superannuation fund investors. In Australia, the Federal Government has committed to assisting private parties manage the risks in greenfield projects. Former Treasurer Joe Hockey was the key instigator of the G20 Finance Minister’s campaign to increase the focus on aims to assist “in managing the risks of infrastructure projects as a means of increasing private sector investment”, including by using “bonds, guarantees, phased grants/availability payments and concessional loans”. Given these trends, it is apparent that the regulatory framework in Australia is likely to continue to be improved to assist superannuation investment in domestic infrastructure projects. The future for investment and deal structuring On the whole, it is generally recognised that superannuation investment in infrastructure will continue to increase. The size of superannuation funds is projected to reach $5 trillion by 2030, and the need for new and diversified investment will only increase. Internationally, the benefits of greenfield infrastructure investment are being recognised by pension funds, and it is clear that the Australian Government is committed to encouraging this investment. However, superannuation funds are continuing to grapple with the transition from brownfield infrastructure asset purchases to investment in greenfield infrastructure development. Through its expertise, experience and the legal frameworks set out in this Best Practice Guide, PwC can assist superannuation funds, as well as experienced Developers and Lenders, in understanding and delivering sound greenfield infrastructure investment. Damian McNair PwC PwC i Contents Introduction i Position papers 1 1 Position paper on liability 3 2 Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties 18 3 Position paper on performance liquidated damages – Power projects 34 4 Position paper on contracting delivery models 63 EPC and EPCM Contracts 104 5 EPC Contracts in the oil and gas sector 105 6 EPC Contracts in the power sector 141 7 EPC Contracts in the process plant sector 180 8 EPCM Contracts: Project delivery through engineering, procurement and construction management contracts 218 9 Splitting an EPC Contract 236 10 Preparing the Employer’s Requirements for a Construction Project 239 Energy 248 11 Construction, operation, regulatory and bankability issues for utility scale renewable energy projects 249 12 The elephant in the room dispute resolution processes for RE IPP programme introduction 297 13 Liquidated damages – Delay and performance 303 14 Offtake and construction interface issues in infrastructure projects 306 15 Operating and maintenance agreements – Key issues 310 16 Performance testing regime 315 17 Monetising utility solutions at master planned community projects 318 PPPs and Concessions 353 18 Comparative analysis of key project issues in Australian PPPS 354 19 Comparative analysis of key issues in D&C contracts in recent social infrastructure PPPS 403 20 Comarative analysis of key issues in Australian Transport Sector PPPS 440 Contents PwC ii General 525 21 Alliancing 526 22 Assignment, novation and other dealings boilerplate clause 529 23 Boilerplate clauses 533 24 Concurrent delay 537 25 Consents and approvals boilerplate clause 542 26 Counterparts boilerplate clause 547 27 Defects liability period – an introduction 553 28 Email and contractual notices 556 29 Export credit financing 560 30 Force majeure clauses 562 31 Force majeure clauses – Revisited 565 32 Further assurances boilerplate clause 568 33 Interpretation boilerplate 572 34 Interpretation boilerplate clause 579 35 Legal risk in the tender process 586 36 Letters of intent 590 37 Liquidated and unliquidated damages 593 38 Material adverse change clauses 597 39 Memorandum of understanding 600 40 Performance bonds and bank guarantees 605 41 Prevention and the enforceability of exclusive remedy clauses 610 42 Proportionate liability 614 43 “Reasonableness” and withholding consent to an assignment of contractual rights 629 44 Security of payment 638 45 Severability boilerplate clause 642 46 Sponsor checklist 646 47 Unilateral discretion in construction contracts 650 48 Variation boilerplate clause 652 49 What is gross negligence? 657 50 Schedule – Variances in definitions 660 Contents PwC iii These papers reflect recent lessons learnt and current case law (notwithstanding the latter they are meant to be more of a practice guide) as of January 2016. Where case law has been included, the papers generally look at a range of common law positions, albeit primarily an English and Australian law position. Please contact us for specific advice on those issues raised rather than relying on these papers. For further information, please contact Damian McNair Partner, Legal M +61 421 899 231 E damian.mcnair@au.pwc.com PwC 1 Position papers PwC 3 1 Position paper on liability Introduction This paper sets out the legal principles that apply to key provisions in construction contracts and focuses on those issues that contractors raise in an attempt to limit their liability. It focuses on international market practice and the position under English law, which most participants in the projects and construction industry in this region are familiar with. Summary Contractors often raise various arguments concerning provisions relating to time and performance which, if accepted, can have serious consequences for an Employer’s ability to recover. Contractors often argue for:  the insertion of an exclusive remedies clause for delay and performance liquidated damages and the removal of any failsafe provisions  the insertion of a general exclusive remedies clause  the deletion of provisions that attempt to obviate the effects of the Prevention Principle  no liability for consequential loss  the exclusion of all implied warranties. This position paper sets out the legal issues that Employers need to be aware of in dealing with these issues. Specifically, we explore:  the operation of liquidated damages clauses and how they can be invalidated  the impact of exclusive remedies clauses on liquidated damages regimes  the rationale for, and meaning of, exclusive remedies clauses under construction contracts  the operation of the Prevention Principle  the operation of consequential loss provisions  the application of implied warranties. It should be emphasised that this paper focuses on the legal risks to Employers; it does not focus on commercial imperatives or technical issues. Position paper on liability PwC 4 How liquidated damages regimes can be invalidated If an exclusive remedies clause is inserted into a contract, the explicit remedies contained in the contract will take on great significance. Under English law, from a construction law perspective, the presence of liquidated damages will be crucial in providing remedies for delay and underperformance. However, if a general exclusive remedies provision is inserted, the Employer may have no recourse to common law damages if the liquidated damages regime is invalidated. Contractors attempt to invalidate liquidated damages clauses in a number of ways. The most common methods of circumventing these clauses are by arguing that:  the liquidated damages clause is a penalty or void for uncertainty  the Employer has caused delay through an act of prevention. Liquidated damages not a genuine pre-estimate of loss, but a penalty If the sum agreed to be imposed by the parties as liquidated damages is, in law (or equity), a penalty, then it will not be enforceable by an Employer (at least to the extent that it is penal in nature). The sum agreed to be imposed as liquidated damages will be regarded as a penalty if it does not represent a genuine pre-estimate of the loss likely to be sustained by the Employer as a result of a delay to completion. As stated by the Privy Council: “…so long as the sum payable in the event of non-compliance with the contract is not extravagant, having regard to the range of losses that it could reasonably be anticipated it would have to cover at the time the contract was made, it can still be a genuine pre-estimate of the loss that would be suffered and so a perfectly valid liquidated damage provision.”1 The question of whether a clause is a penalty is one of construction to be decided upon the terms and circumstances of each particular contract at the time of formation. If it can be established that the sum is not a genuine pre-estimate of loss because it is too great a figure, the provision will be unenforceable at common law and in equity it will be read down the clause and enforce it to the extent that it reflects the damage suffered.2 It makes no difference that the contract specifically states that the clause is not a penalty3 or in fact the contract uses the word “penalty” (as some still do) provided the sum is in reality a genuine estimate of damage (and so follows general common law damages principles) or is intended as a limitation of damage and not in terrorem. 4 However, in all cases where the act in question is a breach of contract, the law will inquire whether the payment provided for in the contract is a “penalty”, in a modern sense of the word, meaning that it is not in reality a genuine pre-estimate of damage and is excessive or “out of all proportion” with the likely loss flowing from the breach.5 In practice, liquidated damages clauses in major infrastructure projects that are financed on a non – or limited recourse basis are not likely to be considered excessive or out of proportion, as they are estimated below the likely loss that an Owner would suffer. Therefore, the more relevant risk is if they are drafted in a way that is too uncertain to be enforced. 1 Xxx 2 Xxx 3 Philips Hong Kong Ltd v The Attorney General of Hong Kong [1993] 61 BLR 49, 59 (Lord Woolf). 4 Jobson v Johnson [1989] 1 WLR 1026; Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205. 5 Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, 86. Position paper on liability PwC 5 Time at large If an Employer prevents the completion of the works in a way not covered by an extension of time clause, then it loses the right to claim liquidated damages. If this occurs, the Contractor cannot complete by the set completion date and it is said that time under the contract has been set “at large”. This means that the Contractor’s obligation is to complete the works within a reasonable time. Time is said to be set at large due to the operation of the Prevention Principle. What is a reasonable time to complete once time has been set at large is a matter of fact dependent on the circumstances as to how time has become at large, the date on which it was set at large and the materials to be able to make a calculation.6 The potential for a liquidated damages clause to be declared a penalty and be read down or invalidated increases the importance of failsafe clauses and other provisions that preserve an Employer’s rights to claim damages at law. Removal of failsafe clauses for delay and underperformance Failsafe provisions in construction contracts attempt to preserve the Employer’s rights to obtain damages at law if for some reason the liquidated damages clauses are deemed unenforceable. A typical failsafe provision for delay provides as follows: If this provision (or any part thereof) is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Employer from claiming delay liquidated damages, the Employer is entitled to claim against the Contractor damages at law as set out in the damages at law schedule for the Contractor’s failure to attain commercial operation by the date for commercial operation up to the aggregate liability for delay liquidated damages. Contractors often argue against such clauses and suggest they should be deleted. They often argue for the inclusion of an exclusive remedies provision and the deletion of any failsafe clause, suggesting that liquidated damages should be an Employer’s sole entitlement for the Contractor’s delay or underperformance. As explained below, exclusive remedies clauses may prevent an Employer from claiming damages at common law in the event that the liquidated damages regimes are for some reason found to be unenforceable. If there is no exclusive remedies clause, then there is no essential need for the inclusion of failsafe clauses. However, if an exclusive remedies clause is inserted – which we advise against below – failsafe clauses must be included to protect the Employer’s ability to recover. If an exclusive remedies clause is present, failsafe clauses provide essential protection if the liquidated damages regimes are for any reason invalidated. While the High Court in Andrews v Australia and New Zealand Banking Group Ltd7 indicated that in equity a penalty can be enforced to the extent it reflects appropriate compensation, that principle will not have application where a liquidated damages clause is considered void for uncertainty, rather than being a penalty because it is excessive in amount. 6 This point was strongly suggested by the Court of Appeal judgments in Widnes Foundry v Cellulose Acetate [1931] 2 KB 393 and finally and satisfactorily concluded by the Supreme Court of Canada in Elsley v J.G. Collins Insurance Agencies Ltd [1978] 2 SCR 916. 7 Ian D Wallace (ed), Hudson’s Building and Engineering Contracts (Sweet & Maxwell, 11th ed, 1994) vol 2, [10.002]. Position paper on liability PwC 6 Exclusive remedies generally Contractors typically attempt to insert a provision stating that the remedies expressly provided for under the construction contract are to the exclusion of any remedies at common law. Contractors also typically attempt to delete any reference to recourse to damages at law. The insertion of an exclusive remedies clause may have far-reaching consequences as it may limit an Employer’s rights to those explicitly articulated in the construction contract. This potentially leaves the Employer without remedies for the Contractor’s breaches of the construction contract, as we explain below. A typical comprehensive exclusive remedies clause is as follows: The Employer and the Contractor agree that their respective rights, obligations and liabilities as provided for in the contract shall be exhaustive of the rights, obligations and liabilities of each of them to the other arising out of, under or in connection with the contract or the works, whether such rights, obligations and liabilities arise in respect or in consequence of a breach of contract or of statutory duty or a tortious or negligent act or omission which gives rise to a remedy at common law. Accordingly, except as expressly provided for in the contract, neither party shall be obligated or liable to the other in respect of any damages or losses suffered by the other which arise out of, under or in connection with the contract or the works, whether by reason or in consequence of any breach of contract or of statutory duty or tortious or negligent act or omission. The effect of this clause would considerably affect the Employer’s ability to recover. The final sentence is particularly comprehensive, as it provides that, other than those clauses in the contract for which a remedy is specifically provided, the Employer would not be able to recover damages from the Contractor for breaches of the engineering, procurement and construction (EPC) Contract or for negligence. It follows that, if there has been a failure by the Contractor to satisfy a contractual obligation, or if the Contractor has been negligent under the contract, then unless the Employer can point to a specific and express remedy under the contract for such breach or negligence, it would be left without a remedy. An EPC Contract will typically provide specific remedies in the form of liquidated damages for delay and underperformance of the project. Delay and underperformance are only two issues, however, for which an Employer will require contractual compliance. There will be numerous other Contractor obligations under the EPC Contract with which the Employer will require compliance and for which a remedy should be available in the event of non-compliance or breach. If a comprehensive exclusive remedies clause is inserted, the Contractor may be able to breach numerous provisions of the EPC Contract, or behave negligently in respect of certain conduct, without consequence. For example, consider the scenario under an EPC Contract in which the Contractor has brought the project to practical completion/commercial operation and the liquidated damages regime is no longer required. After commercial operation, there remain various opportunities and possibilities for breach. One example is the Contractor’s failure to provide spare parts in accordance with the terms of the EPC Contract. The exclusive remedies clause may have the effect of preventing the Employer from claiming common law remedies for breaches of other provisions of the contract in such a situation. Another example is a breach of the Contractor’s warranty that the works will be fit for the purpose reasonably inferable from the contract. Position paper on liability PwC 7 Exclusion of common law damages Commonly, if a liquidated damages clause is found to be unenforceable (because it is a penalty, void or otherwise unenforceable), the Employer, while prevented from claiming liquidated damages, still has the right to claim damages at common law (or in equity may be entitled to enforce an excessive penalty clause to the extent that it would amount to appropriate compensation). Exclusive remedies provisions exclude the ability of an Employer to claim common law damages in the event the liquidated damages regime is declared unenforceable, thereby restricting the Employer’s remedies for delay or underperformance to liquidated damages. If an exclusive remedies clause is inserted, a further question to be determined is to what extent common law damages are unavailable, that is, whether the clause excludes all common law remedies or only those provisions for which liquidated damages are available. It is clear that whether the terms of a contract constitute a codification of the rights and liabilities of the parties to it (including a complete statement of those rights and liabilities where one party defaults in a contractual obligation so as to exclude common law rights to damages) depends on the construction of each individual contract.8 It is well established that if a party’s common law right to sue for damages for breach of contract is to be removed contractually, it must be done by clear words.9 Courts have held that clear wording may remove the common law right to damages. This view has been followed in a number of cases, including Hancock v BW Brazier (Anerley) Ltd [1966] 1 WLR 1317 (CA); Billyack v Leyland Construction Co Ltd [1968] 1 WLR 471; Photo Production Ltd v Securicor Transport Ltd [1980] AC 827 and HW Nevill (Sunblest) Ltd v William Press & Son Ltd [1981] 20 BLR 78. The High Court in Concut Pty Ltd v Worrell10 has said that “clear words are needed to rebut the presumption that a contracting party does not intend to abandon any remedies for breach of the contract arising by operation of the law”. 11 It was held in Peak Construction (Liverpool) Ltd v McKinney Foundations Ltd12 that a proprietor may lose his right to rely upon a liquidated damages clause providing for liquidated damages in the event of delay in completion if the proprietor caused or contributed to the delay.13 However, in Billyack v Leyland Construction Co Ltd14 Davies LJ stated: “It requires very clear words to debar a building Employer from exercising his ordinary rights of suing if the work done is not in accordance with the contract.” The possibility of broadening this position was considered by Lord Diplock in Photo Production Ltd v Securicor Transport Ltd. 15 Since the obligations implied by law in a commercial contract are those which, by judicial consensus over the years or by Parliament in passing a statute, have been regarded as obligations that a reasonable businessman would realise that he was accepting when he entered into a contract of a particular kind, the court’s view of the reasonableness of any departure from the implied obligations that would be involved in construing the express words of an exclusion clause in one sense that they are capable of bearing rather than another is a relevant consideration in deciding what meaning the words were intended by the parties to bear. But this does not entitle the court to reject the exclusion clause, however unreasonable the court itself may think it is, if the words are clear and fairly susceptible of one meaning only. 8 Keith Pickervance, ‘Calculation of a Reasonable Time to Complete when Time is at Large’, [2006] International Construction Law Review 167, 168. 9 (2012) 247 CLR 205. 10 Stephen Furst and Sir Vivian Ramsey (eds), Keating on Construction Contracts, (Sweet & Maxell, 8th ed, 2006), [10.023]. 11 Hancock v BW Brazier (Anerley) Ltd [1966] 1 WLR 1317,1334 (Denning MR); Billyack v Leyland Construction Co Ltd [1968] 1 WLR 471, 475 (Edmund Davies LJ); H W Nevill (Sunblest) Ltd v William Press & Son Ltd (1981) 20 BLR 78, 88 (Judge Newey). 12 (2000) 176 ALR 693. 13 Ibid, 699-70; see also Stocznia Gdanska SA v Latvian Shipping Co [1998] 1 WLR 574. 14 [1970] 1 BLR 111. 15 See also Spiers Earthworks Pty Ltd v Landtec Projects Corporation Pty Ltd [No 2] [2012] WASCA 53, [49]. Position paper on liability PwC 8 On a broad interpretation, this suggests that if, on the structure of the contract as a whole, it appears that a party has surrendered its rights to common law damages by the insertion of a particularly comprehensive exclusive remedies clause, that party may not have any remedies other than those specifically and particularly stated in the contract. This argument becomes increasingly persuasive when considered in light of the decision in Temloc Limited v Erril16 in which it was held that the word “nil” in a damages annexure was evidence that the parties intended no liability for either liquidated or unliquidated damages. Nourse LJ noted: “I think it clear, both as a matter of construction and as one of common sense, that if…the parties complete the relevant part of the Appendix,…then that constitutes an exhaustive agreement as to the damages which are or are not to be payable by the Contractor in the event of his failure to complete the works on time.”17 These cases suggest that the inclusion of an exclusive remedies clause, then, is a step that can have extremely significant consequences. The effect of an exclusion of common law damages Therefore, while the insertion of an effectively drafted exclusive remedies clause will prevent the Employer from claiming common law damages for delay or underperformance in the event that the liquidated damages clause is declared invalid, it may have far-reaching effects on other clauses of the contract. Rule at law against double recovery It is a well-established principle that the law (which now embraces equity) will not permit a plaintiff, whatever procedural device is used, to recover more than the damages which have been suffered, no matter what the cause of action: Baxter v Obacelo Pty Ltd (2001) 205 CLR 635 as most recently applied in Ewin v Vergara (No 3) [2013] FCA 1311. Given the possible severe and wide ranging consequences for both parties if an exclusive remedies clause is inserted, and in light of the well-established (in English and Australian law) principle of double recovery which will operate to have the same effect as an exclusive remedies clause (that is, prohibit an Owner from recovering, for example, liquidated damages under contract for delay and damages at law for the same delay), it is prudent that an exclusive remedies clause be excluded from a contract. Proposed solutions One option is for an Employer to accept the Contractor’s exclusive remedies clause, but carefully to elaborate those clauses of the contract for which a remedy is required in the event of breach. These express remedies could then be specifically included in the contract and could operate alongside the exclusive remedies clause. However, in our view, such a strategy is risky, because the Employer would be required to identify all potential breaches of the EPC Contract, and also to consider which remedies should be expressly identified to deal with such breaches. In our view, it is not possible to envisage the different ways in which a Contractor may breach its contractual obligations, and the consequences the Employer may suffer as a result of the breach. The preferable solution is to resist the inclusion of an exclusive remedies clause, thereby ensuring maximum latitude to claim for damages at law if the liquidated damages regime is for some reason declared unenforceable. Failing this approach, the other option is to include a “code of rights” provision in the EPC Contract, providing that, except where express remedies are specifically provided under the contract (for example, provisions providing for liquidated damages), each party will be able to claim common law damages for breaches of the contract. 16 [1968] 1 WLR 471. 17 [1980] AC 827. Position paper on liability PwC 9 The operation of the Prevention Principle Rationale There are various rationales for the existence of the Prevention Principle under English law. These have been variously suggested as:  the principle that a party should not be able to recover from damages for what that same party has caused18  an implied term or implied supplemental contract19  waiver or estoppels20  unjust enrichment. Others have suggested that there is in fact no coherent overarching rationale for the Prevention Principle or that it may be regarded as a particular manifestation of the obligation to cooperate implied as a matter of law in all contracts.21 In any case, the fundamental considerations are of fairness and reasonableness.22 Operation The operation of the Prevention Principle will ensure that an Employer will lose its right to claim liquidated damages for delay if that delay was due to its own, employee’s or agent’s defaults, where there is no extension of time clause that specifically provides for extensions due to acts or defaults of the Owner and an extension has been validly granted thereunder.23 A claim that the Prevention Principle operates to set time at large usually arises in the following circumstances:  where a Contractor alleges that the power to extend time has not been exercised, or has been exercised improperly  where there is no clause under the contract to extend time for the Employer’s act of delay, or where that power cannot be exercised in the circumstances. What acts or omissions of the Employer bring the Prevention Principle into operation? Courts generally have regarded any wrongful act or fault as sufficient to enliven the principle. It is not necessary that the act constitutes a breach of contract.24 The broadest view is that any act of the Employer, regardless of its fault element, is sufficient to engage it. Variations, whether authorised under the original contract or subsequently agreed, are regarded as acts of prevention for the purposes of the doctrine.25 In considering whether an extension of time clause provides for the granting of extensions of time for Employer-caused delay, the extension of time clause will be construed contra proferentem against the Employer. It is established that general or ambiguous words in an extension of time clause, referring to such matters as “events beyond the control of the Employer”, will not entitle the Employer to the benefit of the liquidated damages regime.26 Where the extension of time clause provides specifically for the Employer’s 18 [1987] 39 BLR 30. 19 Ibid 39. 20 Peak Construction (Liverpool) Ltd v McKinney Foundations Ltd [1970] 1 BLR 111. 21 SBS International Pty Ltd v Venuti Nominees Pty Ltd [2004] SASC 151, [11] (Besanko J). 22 Ibid. 23 SMK Cabinets v Hili Modern Electrics [1984] VR 391, 397 (Brooking J). 24 Secured Income Real Estate (Australia) Ltd v St Martins Investments Pty Ltd (1979) 144 CLR 596, 607 (Mason J); Spiers Earthworks Pty Ltd v Landtec Projects Corporation Pty Ltd (No 2) [2012] WASCA 53, [46]. 25 Wallace, above n 5. 26 Doug Jones, “Can prevention be cured by time bars?” (2009) (Paper 158) Society of Construction Law. Position paper on liability PwC 10 breach, waiver or prevention, the liquidated damages regime will be preserved. As stated by Salmon LJ in Peak Construction (Liverpool) Ltd v McKinney Foundations Ltd (Peak):27 “The liquidated damages and extension of time clauses in printed forms of contract must be construed strictly contra proferentem. If the Employer wishes to recover liquidated damages for failure by the Contractors to complete on time in spite of the fact that some of the delay is due to the Employers’ own fault or breach of contract, then the extension of time clause should provide, expressly or by necessary inference, for an extension on account of such a fault or breach on the part of the Employer.” 28 One of the more contentious aspects of this area of law concerns the interaction of conditions precedent to the granting of an extension of time with the operation of the Prevention Principle. The issue is whether the Prevention Principle is subject to an administrative act (such as the provision of notice by the Contractor) or whether it can operate independently of such procedural requirements of particular contracts. Case law on this point is divided. In Gaymark v Walter Construction (Gaymark),29 the contract under dispute provided that a notice of delay was to be given within 14 days of the cause of delay arising. The Supreme Court of the Northern Territory reaffirmed an arbitral award that found that, even though the notice requirements were not complied with by the Contractor, because at least some of the delay was caused by the Employer, the right to claim liquidated damages was lost and time was set at large. Gaymark suggests that the Prevention Principle overrides conditions precedent. This view has been subjected to strong academic criticism.30 Later cases have suggested that conditions precedent must be satisfied before the Prevention Principle can have application. Indeed, in Turner Corporation Limited (Receiver and Manager Appointed) v Austotel Pty Ltd31 Cole J stated that the builder could not: “... claim that the act of prevention which would have entitled it to an extension of the time for practical completion resulted in its inability to complete by that time. A party to a contract cannot rely upon preventing conduct of the other party where it failed to exercise a contractual right which would have negated the affect [sic] of the preventing conduct.”32 A further question regarding the scope of the Prevention Principle concerns what is actually invalidated by the Employer’s act of prevention. If the Employer causes four days of delay to a programme, and the Contractor is 100 days late in delivery of the project, can the Employer recover 96 days of liquidated damages, or is the entire liquidated damages regime invalidated? In such a scenario, what is considered to be a reasonable time to complete? Early authority on this point favoured the view that any act of prevention by the Employer invalidated the entire liquidated damages regime. In Holme v Guppy33 the delay in completion was five weeks; the Employer was responsible for four weeks of delay and the Contractor for one week of delay. The court found that the Employer was not entitled to any liquidated damages due to its act of prevention. In Hudson’s Building and Engineering Contracts, Wallace notes that: “... (unless) there is a sufficiently specific clause, it is not open to the Employer or his A/E (independent engineer) where the contract date has ceased to be applicable, to make out a kind of debtor and creditor account allowing so many days or weeks for delay caused by the Employer and, after crediting that period to the builder, to seek to charge him with damages at the liquidated rate for the remainder.”34 27 Multiplex Constructions (UK) Ltd v Honeywell Control Systems Ltd [2007] BLR 195. 28 Wallace, above n 5. 29 [1970] 1 BLR 111. 30 Ibid, 121; see also D & M (Australia) Pty Ltd v Crouch Developments Pty Ltd [2011] WASCA 109, accepting Peak. 31 [1999] 16 BCL 449. 32 Ian D Wallace, “Prevention and Liquidated Damages: A Theory Too Far?” (2002) 18 Building and Construction Law 82. 33 Turner Corporation Ltd (Receiver and Manager Appointed) v Austotel Pty Ltd (1994) 13 BCL 378. 34 Ibid. Turner has been accepted as correct in Peninsula Balmain Pty Ltd v Abigroup Contractors Pty Ltd (2002) 18 BCL 322; 620 Collins Street Pty Ltd v Abigroup Contractors Pty Ltd (No 2) [2006] VSC 491. McLure P indicated that all Australian courts were bound to follow that approach in Spiers Earthworks Pty Ltd v Landtec Projects Corporation Pty Ltd (No 2) [2012] WASCA 53, [53]-[56]. Position paper on liability PwC 11 This view appears to be based on the needs of certainty and predictability and finds its foundation in the classic case of Peak. More recent authority suggests that the Employer’s delay and the Contractor’s delay could be in some circumstances divisible for the purposes of determining and enforcing liquidated damages, but remains circumspect in light of Peak’s authority. In Rapid Building Group Ltd v Ealing Family Housing Association Ltd35 Lloyd LJ remarked that: “… I was somewhat startled to be told in the course of the argument that if any part of the delay was caused by the Employer, no matter how slight, then the liquidated damages clause in the contract… becomes inoperative. “I can well understand how that must necessarily be so in a case in which the delay is indivisible and there is a dispute as to the extent of the Employer’s responsibility for that delay. But where there are, as it were, two separate and distinct periods of delay with two separate causes, and where the dispute relates only to one of those two causes, then it would seem to me just and convenient that the Employer should be able to claim liquidated damages in relation to the other period.”36 Nevertheless, Lloyd LJ went on to note that “it was common ground before us that is not a possible view…in the light of the decision of the Court of Appeal in Peak’s case, and therefore I say no more about it.”37 Accordingly, the classic case of Peak remains dominant, with the subsequent line of authority suggesting that where an act of prevention goes to part of the delay but not the whole, the entire liquidated damages clause will be invalidated.38 This traditional view has recently been reinforced in Australia in SBS International Pty Ltd v Venuti Nominees Pty Ltd, 39 where Besanko J held that, in a situation where delay to the completion date is caused by the Contractor as well as the Principal, it is not open to a court to apply the liquidated damages clause to the delay specifically caused by the Contractor: “In those cases where both Principal and Contractor are responsible for delay, the liquidated damages clause will be held inapplicable unless there is a contractual provision by way of an appropriate extension of time clause which accommodates or deals with the delay caused by the contract of the Principal”. 40 To summarise, an Employer will not lose its rights to claim liquidated damages if:  the delay is due wholly or in part to an act of prevention  there is a provision in the contract providing for extensions of time due to acts of prevention  an extension of time has been certified pursuant to the contract. It is prudent to include a provision permitting the Employer to make an extension of time at its discretion, even where the Contractor has not requested one. Such a provision makes it possible to avoid the situation where a Contractor is entitled to an extension of time due to any act of prevention, but has not applied for one on the basis that it can rely on the Prevention Principle. We suggest that the contract should provide that a cause of delay entitling the Contractor to an extension of time includes:  any act, omission or default by the Employer, the Employer’s representative and their agents, employees and contracting counterparties 35 (1838) 3 M&W 387. 36 Wallace, above n 5, [10.025]. 37 (1984) 29 BLR 5. 38 [2007] BLR 195; Pickervance, above n 6, 177. 39 (1984) 29 BLR 5, 19. 40 Wallace, above n 5, [10.040]. Position paper on liability PwC 12  a variation, except where that variation is caused by an act, omission or default of the Contractor or its sub contractors, agents or employees. The contract should also include a condition precedent provision with which the Contractor must comply before an extension of time can be granted. Can the Prevention Principle be contracted out of? The question arises whether the Prevention Principle can be explicitly contracted out of, so that a liquidated damages regime can remain on foot despite the Contractor being prevented due to the Employer delaying the works. As well as providing for extensions of time for acts or omissions of the Employer, our standard EPC Contract attempts to contract out of the Prevention Principle as follows:  Any principle of law or equity (including the Prevention Principle and those which might otherwise entitle the Contractor to relief), which might otherwise cause the date for commercial operation to be set at large and liquidated damages unenforceable, will not apply  For the avoidance of doubt, a delay caused by any act or omission of the Employer or any failure by the Employer or the Employer’s representative to comply with this clause will not cause the date for commercial operation to be set at large  Nothing clauses 1 or 2 will prejudice any right of the Contractor to claim an extension of time or delay costs in accordance with this contract for that delay. While we believe that this clause is valid, and that the Prevention Principle can be contracted out of, we must emphasise that this view has not yet received judicial confirmation. There do not appear to be any cases directly in point. However, general principles of law in related areas may provide guidance in this area. The doctrine of freedom of contract suggests that parties are given considerable latitude in determining the terms of their commercial bargain. In 1993, the Privy Council of the United Kingdom quoted approvingly the view that: “…the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. It has no place where there is no oppression.”41 Generally speaking, “although the principle of freedom of contract rests on the premise that individuals are free to make agreements as they wish, the public interest in freedom of contract can be outweighed by other public policy considerations.”42 Providing an agreement does not offend public policy, then it will be enforced in its terms. However, equity may prevent the reliance on contractual provisions where there is demonstrated unconscionable conduct. As yet, there is no judicial consideration of such an approach in relation to reliance upon a clause excluding the Prevention Principle. Indirect and consequential loss Introduction Contractors often attempt to limit their liability by attempting to exclude all “consequential loss” from liability, or by explicitly excluding certain heads of loss under the construction contract. 41 [2004] SASC 151. 42 Ibid, [12] (Besanko J). Position paper on liability PwC 13 It is common practice in standard form EPC Contracts to refer to both “indirect” and “consequential” loss or damage in exclusion of liability clauses. Under Australian law, the view had been that there was no legal difference between the words “indirect” and “consequential” in exclusion of liability clauses, until relatively recently. However, case law from Victoria that is likely to be applied in other Australian jurisdictions has now held that consequential loss has a broader meaning than previously assumed. The following explains this change and how parties should interpret these words in commercial negotiations. Under English law, the distinction between indirect and consequential loss, and direct loss, is less certain. The scope of indirect or consequential loss or damage Position under English law The well-known English case of Hadley v Baxendale43 provides that where a party to a contract is in breach, the damages to which the other party is entitled falls under two limbs, namely, damages such as may fairly and reasonably be considered:  to arise naturally, ie according to the usual course of things, from such a breach of contract (often referred to as direct loss or damage) (first limb)  to be in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of contract (often referred to as indirect loss or damage) (second limb). Under English law, the term “consequential” is confined to the second limb of the rule in Hadley v Baxendale. On this view, the term “indirect or consequential loss or damage” would not include any loss that arises naturally upon the breach, but would include loss or damage that was in the contemplation of both parties, at the time the contract was made, as the probable result of its breach. Under English law, in determining whether a loss is direct or indirect, it has been held that the enquiry is whether the losses arise naturally and in the ordinary course of things.44 English case law has considered which types of loss are typically seen as direct and which are considered indirect or consequential. It is important to emphasise that the classification of loss is often dependent on the specific factual scenarios and contractual provisions at issue, and in practice it is often difficult to determine whether a loss falls within the first or second limb of Hadley v Baxendale. However, the following types of losses have frequently been considered direct loss by courts:  loss of profits  loss of revenue  loss of opportunity  increased expenses or wasted expenditure. Position under Australian law The Australian courts have previously supported the above English view of indirect or consequential loss or damage as loss or damage that was in the contemplation of both parties at the time the contract was made, as the probable result of the breach. 43 Philips Hong Kong Ltd v The Attorney General of Hong Kong [1993] 61 BLR 49, 58. See also AMEV-UDC Finance Ltd v Austin (1986) 162 CLR 170, 190 (Mason and Wilson JJ). 44 Australian Securities and Investments Commission v Fortescue Metals Group Ltd (2011) 190 FCR 364, [222]. Position paper on liability PwC 14 However, in the case of Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd45 (Peerless), the Victorian Court of Appeal moved away from the “second limb test” and decided that the term “consequential loss” should be given its ordinary and natural meaning as would be conceded by ordinary reasonable business persons. In applying this principle, the court drew a distinction between:  loss that every plaintiff in a like situation will suffer (normal loss)  anything beyond the normal measure, such as profits lost or expenses incurred through breach (consequential loss). Peerless was highly influential in the recent decision of Alstom Ltd v Yokogawa Australia Pty Ltd (No 7) 46 (Alstom), where the Supreme Court of South Australia considered a clause excluding Yokogawa’s liability as sub contractor for “any indirect, economic or consequential loss whatsoever”. The terms of the contract required the sub contractor to pay damages if it did not complete the works on time or if the works did not meet the performance tests. Alstom made claims against the sub contractor and sought compensation in relation to breaches of these obligations, asserting that the breaches had resulted in losses that flowed naturally from each breach, and therefore were within the first limb of Hadley v Baxendale. The sub contractor rejected this assertion and relied upon the exclusion clause, submitting that it should be read more generally to include losses that occurred as a consequence of breach of contract. The Court considered these claims, and held that the losses claimed by Alstom fell within the first limb, but the breadth of the exclusion clause meant that the sub contractorwas not liable for damages occurring as a consequence of any breaches of contract: “The expression “indirect … or consequential loss” appears, in this case, as part of a freestanding and powerfully expressed exclusion clause. It is not affected by the immediate presence of any concession as to liability which it might qualify, although it must be read against the background of the qualified exposure of [the sub contractor] to the exclusive remedies of Liquidated Damages and reimbursement of Performance Guarantee Payments. The Article in question was intended to operate in respect of potential liability for loss incurred by Alstom, which was caused by a breach of contract by [the sub contractor] in circumstances other than those giving rise to the payment of Liquidated Damages and reimbursement of Performance Guarantee Payments. The words must be given their ordinary and natural meaning. In those circumstances any loss consequential or following, immediate or eventual, flowing from a breach of contract by [the sub contractor] is excluded from recovery by Alstom.”47 In so doing, the Court noted Peerless was the preferred precedent over the English cases. In 2013, the West Australian Supreme Court decision of Regional Power Corporation v Pacific Hydro Group Two Pty Ltd (No 2)48 (Regional Power) rejected both the English approach to the construction of the term “consequential loss” as falling under the second limb of Hadley v Baxendale, and the view adopted by Peerless. Regional Power concerned a PPA entered into between Regional Power Corporation (SECWA) and Pacific Hydro Pty Ltd for the supply of electricity. The power station suffered an outage resulting in flooding which led to the power station being inoperative for two months. Resultantly, SECWA claimed damages for breach of the PPA consisting of costs relating to the hiring of replacement diesel generators, cranes and fuel required to run the extra generators; and wages, travel, accommodation and meal expenses of the additional Operators required during that period. 45 [1854] 9 Exch 341. 46 FG Minter Ltd v Welsh Health Technical Services Organisation [1980] 13 BLR 1. 47 (2008) 19 VR 358. 48 [2012] SASC 49. 49 Ibid, 82. Position paper on liability PwC 15 Pacific Hydro argued that the damages claimed by SECWA were indirect or consequential losses and accordingly were excluded from recovery by the following clause 26.1: Neither the Project Entity nor SECWA shall be liable to the other party in contract, tort, warranty, strict liability, or any other legal theory for any indirect, consequential, incidental, punitive or exemplary damages or loss of profits. The Court rejected both the Hadley v Baxendale and Peerless positions in favour of the well settled construction approach by the High Court in Darlington Futures, stating: “To reject the rigid construction approach towards the term “consequential loss” predicated upon a conceptual inappropriateness of invoking the Hadley v Baxendale dichotomy as to remoteness of loss, only then to replace that approach by a rigid touchstone of the ‘normal measure of damages’ and which always automatically eliminates profits lost and expenses incurred, would pose equivalent conceptual difficulties. Accordingly, I doubt whether the [93] observations in Environmental Systems were intended to carry any general applicability towards establishing a rigid new construction principle for limitation clauses going much beyond the presenting circumstances of that case. The natural and ordinary meaning of the words of cl 26.1, begins with these words themselves, assessed in their place within the context of the PPA as a whole. That, on my assessment, is the correct approach to a limitation or exclusion clause required by Darlington Futures Ltd v Delco Australia Pty Ltd, as recently applied by the Western Australia Court of Appeal in Electricity Generation Corporation t/as Verve Energy v Woodside Energy Ltd [38], [42] (McLure P), [138], [140] (Murphy JA)… Construing 26.1 within the PPA as a whole, the court should not be artificially fettered towards assessing the character of an economic loss by rather vague criteria of whether or not the loss arose ‘in the ordinary course of things’. Nor should the court be oriented from the start towards trying to determine if a claimed loss falls under the equally porous concept of a ‘normal measure of damage.” 50 Effect on drafting In summary, there are now three different approaches to the meaning of the words “indirect or consequential” when used in an exclusion clause (or limitation clause, in the instance of Regional Power):  the English approach, where the words are construed as a reference to damages resulting from special circumstances under which the contract was made communicated by one party to the other  the Peerless/Alstom approach, where the word “consequential” was said to refer to everything beyond the normal measure of damages, such as profits lost or expenses incurred through breach  the Regional Power approach, where the words are said to exclude losses that are in some way less direct and more removed when considered in the context of the transaction at hand. Contracts governed by Australian law Darlington Futures holds that limitation (or exclusion) clauses excluding certain categories of loss and damage must be interpreted according to their natural and ordinary meaning, read in the light of the contract as a whole, thereby giving due weight to the context in which the clause appears including the nature and object of the contract. This principle of interpretation must be applied by courts in Australia. The problem however is whilst the Darlington Futures decision confirms the contextual, commercial approach to the interpretation of commercial contracts in Australia, there is potential for significant differences in what would, in a given situation, constitute the ordinary and natural meaning of “consequential loss”, given the clear requirement that losses claimed be interpreted in context of the contract in question. This is highlighted by the 50 [2013] WASC 356. 51 (1986) 161 CLR 500. Position paper on liability PwC 16 recent conflicting principles as to the scope of “consequential loss” taken by the states below (noting the question is yet to be considered in Queensland, Tasmania, the Australian Capital Territory or Northern Territory):  Victoria, New South Wales and South Australia: “consequential loss” is what an ordinary reasonable business person would consider consequential loss ie everything beyond the normal measure of loss (loss that every plaintiff in a like situation will suffer). Lost profits and expenses incurred as a result of breach were given as two examples of consequential losses: Peerless; Alstom  Western Australia: “consequential loss” is given its natural and ordinary meaning, read in light of the contract as a whole (ie rejecting the above position and reinforcing the High Court position): Regional Power. As a result of these decisions, the term “indirect or consequential” should no longer be interpreted as confined to the second limb of the rule in Hadley v Baxendale. Instead, any exclusion of indirect or consequential loss should be understood as also excluding some categories of loss that would otherwise be considered to fall under the first limb of Hadley v Baxendale; to be determined by construing the clause according to its natural and ordinary meaning, read in the light of the contract as a whole. Contracts governed by English law In contracts governed by English law, the following consequential loss clause should be included: “Without prejudice to the Employer’s right to recover liquidated damages or damages at law for delay or underperformance under clauses 24 and 25 or where otherwise stated in the contract, neither party is liable to the other under the contract, law of tort, including negligence, statute, inequity or otherwise for any kind of indirect or consequential loss or damage including, loss of use, loss of profit, loss of production or business interruption which is connected with any claim arising under the contract or the subject matter of the contract.” The wording of this clause permits the Employer a certain degree of latitude. In cases where the Contractor has caused loss, the Employer can argue that because of the use of the word “including”, the expressly listed types of loss are in fact forms of direct loss that are thereby recoverable. This approach has authority to commend it. In Pegler Ltd v Wang (UK) Ltd,52 the relevant exclusion clause provided that: “Wang shall not in any event be liable for any indirect, special or consequential loss, howsoever arising (including but not limited to loss of anticipated profits or of data) in connection with or arising out of the supply, functioning or use of the hardware, the software or the services…”53 Despite the use of the word “including”, the court held that the clause only excluded losses falling under the second limb of Hadley v Baxendale. It was noted by Judge Bowsher QC that: “The reference by the words in brackets to loss of anticipated profits does not mean that the exclusion effected by this clause includes all loss of profits: it is plain from the context that only loss of profits which are of the character of indirect, special or consequential loss are referred to.”54 It is certainly arguable that a court would adopt the same approach when considering our proposed clause, so that, for example, losses of profits that could be classified as direct could be recoverable by the Employer. 52 [2013] WASC 356, [96-97, 116]. 53 (1986) 161 CLR 500, [16]. 54 [2000] BLR 218. Position paper on liability PwC 17 Courts have interpreted similar consequential loss clauses in ways that emphasise the difference between those losses commonly thought to be direct and other forms of indirect loss. In BHP Petroleum Ltd v British Steel PLC, 55 Rix J considered the following consequential loss clause: “Neither the supplier nor the purchaser shall bear any liability to the other…for loss of production, loss of profits, loss of business or any other indirect losses or consequential damages arising during and/or as a result of the performance or non-performance of this contract.” Rix J interpreted this clause quite radically by construing the clause to read “for loss of production, loss of profits, loss of business or indirect or consequential damages of any other kind”, as his Honour found that the express heads of loss could not be construed as forms of indirect or consequential loss. However, Rix J’s interpretation of this clause is somewhat unusual, albeit in favour of the Employer. We favour the use of our clause, which is less radical and, given the authority in Pegler v Wang, would permit the Employer to argue persuasively for recovery of those losses that could be classified as direct. Given the unclear position under Australian law, parties must also ensure that an exclusion of liability clause is carefully drafted. Importantly, the clause should set out clearly and exhaustively expressed in detail those losses which are intended to be categorised as consequential. Where presented with a clause excluding liability for consequential loss, Owners must expressly state the categories of loss for which the Contractor will be liable. This essentially means that Owners will need to include a definition of Direct Loss which would identify losses that are within the contemplation of the parties, eg in a project financing of a power or process plant project this should include loss of revenue under a corresponding off take agreement. Clearly this will be difficult to negotiate, but this should be the starting position., Exclusion of implied warranties Contractors often propose to exclude terms implied by law. A general exclusion may be expressed as follows: The parties agree that the warranties in this clause and any other warranties expressed elsewhere in the contract are the limit of the Contractor’s warranties and are to the exclusion of any implied warranties at law. Despite such a clause, certain warranties cannot be excluded by contractual agreement. Nevertheless, we would agree to the inclusion of such a clause excluding implied warranties only if the list of express warranties is comprehensive. These warranties will usually be project specific, but Employers should take great care to ensure that their ability to recover is protected. 55 Ibid, 226. 56 Ibid, 227. 57 [1999] 2 Lloyd’s LR 583. PwC 18 2 Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties Introduction This paper sets out the legal principles that apply to key provisions in EPC Contracts, and focuses on those issues that Contractors raise in an attempt to limit their liability. Contractors often raise various arguments concerning provisions relating to time and performance which, if accepted, can have serious consequences for an Owner’s ability to recover. Contractors often argue for:  the insertion of an exclusive remedies clause for delay and performance liquidated damages and the removal of any failsafe provisions  the insertion of a general exclusive remedies clause  no liability for consequential loss  the exclusion of all implied warranties  the deletion of provisions that attempt to obviate the effects of the Prevention Principle. This position paper sets out the legal issues that Owners need to be aware of in dealing with these issues. Specifically, we explore:  the operation of liquidated damages clauses and how they can be invalidated  the impact of exclusive remedies clauses on liquidated damages regimes  the rationale for, and meaning of, exclusive remedies clauses under EPC Contracts  the operation of the Prevention Principle  the operation of consequential loss provisions  the application of implied warranties. It should be emphasised that this paper focuses on the legal risks to Owners; it does not focus on commercial imperatives or technical issues. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 19 How liquidated damages regimes can be invalidated If an exclusive remedies clause is inserted into a contract, the explicit remedies contained in the contract will take on great significance. From a construction law perspective, the presence of liquidated damages will be crucial in providing remedies for delay and underperformance. However, if a general exclusive remedies provision is inserted, the Owner may have no recourse to common law damages if the liquidated damages regime is invalidated. Contractors attempt to invalidate liquidated damages clauses in a number of ways. The most common methods of circumventing these clauses are:  by arguing that the liquidated damages clause is a penalty or void for uncertainty  by arguing that the Owner has caused delay through an act of prevention. Liquidated damages not a genuine pre-estimate of loss but a penalty If the sum agreed to be imposed by the parties as liquidated damages is, in law, a penalty, then it will not be enforceable by an Owner. The sum agreed to be imposed as liquidated damages will be regarded as a penalty if it does not represent a genuine pre-estimate of the loss likely to be sustained by the Owner as a result of a delay to completion. The High Court of Australia has recently considered the doctrine of penalties and considered that equity and common law have a role to play in considering their validity. The court provided a wide definition of a penalty, stating: “In general terms, a stipulation prima facie imposes a penalty on a party (the first party) if, as a matter of substance, it is collateral (or accessory) to a primary stipulation in favour of a second party and this collateral stipulation, upon the failure of the primary stipulation, imposes upon the first party an additional detriment, the penalty, to the benefit of the second party.”1 The question of whether a clause is a penalty is one of construction to be decided upon the terms and circumstances of each particular contract at the time of formation. If it can be established that the sum is not a genuine pre-estimate of loss because it is too great a figure, the provision will be unenforceable at common law and in equity it will be read down to the extent that it reflects appropriate compensation.2 It makes no difference that the contract specifically states that the clause is not a penalty3 or in fact the contract uses the word penalty” (as some still do) provided the sum is in reality a genuine estimate of damage (and so follows general common law damages principles) or is intended as a limitation of damage and not in terrorem. 4 However, in all cases where the act in question is a breach of contract, the law will inquire whether the payment provided for in the contract is a “penalty”, in a modern sense of the word, meaning that it is not in reality a genuine pre-estimate of damage and is excessive or “out of all proportion” with the likely loss flowing from the breach.5 In practice, liquidated damages clauses in major infrastructure projects that are financed on a non or limited recourse basis are not likely to be considered excessive or out of proportion, as they are generally estimated below the likely loss that an Owner would suffer. Therefore, the more relevant risk is if they are drafted in a way that is too uncertain to be enforced. 1 Andrews v Australian and New Zealand Banking Group Ltd (2012) 247 CLR 205, 216. 2 Ibid. 3 Jobson v Johnson [1989] 1 WLR 1026; Andrews v Australia and New Zealand Banking Group Ltd (2012) 247 CLR 205. 4 Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, 86. 5 This point was strongly suggested by the Court of Appeal judgments in Widnes Foundry v Cellulose Acetate [1931] 2 KB 393 and finally and satisfactorily concluded by the Supreme Court of Canada in Elsley v J.G. Collins Insurance Agencies Ltd [1978] 2 SCR 916. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 20 Time at large If an Owner prevents the completion of the works in a way not covered by an extension of time clause, then it loses the right to claim liquidated damages. If this occurs, the Contractor cannot complete by the set completion date and it is said that time under the contract has been set “at large”. This means that the Contractor’s obligation is to complete the works within a reasonable time. Time is said to be set at large due to the operation of the Prevention Principle. What is a reasonable time to complete once time has been set at large, is a matter of fact dependent on the circumstances as to how time has become at large, the date on which it was set at large, and the materials to be able to make a calculation.6 The potential for the liquidated damages clause to be declared invalid or otherwise inoperative indicates the importance of failsafe clauses and other provisions which preserve an Owner’s rights to claim damages at law. Removal of failsafe clauses for delay and underperformance Failsafe provisions in EPC Contracts attempt to preserve the Owner’s rights to obtain damages at law if for some reason the liquidated damages clauses are deemed unenforceable. A typical failsafe provision for delay provides as follows: If this provision (or any part thereof) is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Owner from claiming Delay Liquidated Damages, the Owner is entitled to claim against the Contractor damages at law as set out in the Damages at Law Schedule for the Contractor’s failure to attain Commercial Operation by the Date for Commercial Operation up to the aggregate liability for Delay Liquidated Damages. Contractors often argue against such clauses and suggest they should be deleted. They often argue for the inclusion of an exclusive remedies provision and the deletion of any failsafe clause, suggesting that liquidated damages should be an Owner’s sole entitlement for the Contractor’s delay or underperformance. As explained below, exclusive remedies clauses may prevent an Owner from claiming damages at common law in the event that the liquidated damages regimes are for some reason found to be unenforceable. If there is no exclusive remedies clause, then there is no essential need for the inclusion of failsafe clauses. However, if an exclusive remedies clause is inserted – which we advise against below – failsafe clauses must be included to protect the Owner’s ability to recover. If an exclusive remedies clause is present, failsafe clauses provide essential protection if the liquidated damages regimes are for any reason invalidated. Exclusive remedies generally Contractors typically attempt to insert a provision stating that the remedies expressly provided for under the EPC Contract are to the exclusion of any remedies at common law. Contractors also typically attempt to delete any reference to recourse to damages at law. The insertion of an exclusive remedies clause may have far-reaching consequences as it may limit an Owner’s rights to those explicitly articulated in the EPC Contract. This potentially leaves the Owner without remedies for the Contractor’s breaches of the EPC Contract, as we explain below. 6 Keith Pickervance, ‘Calculation of a Reasonable Time to Complete when Time is at Large’, [2006] International Construction Law Review 167, 168. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 21 Exclusion of common law damages Commonly, if a liquidated damages clause is found to be unenforceable (because it is a penalty, void or otherwise unenforceable), the Owner, while prevented from claiming liquidated damages, still has the right to claim damages at common law (or in equity it may have the right to enforce the clause to the level that represents appropriate compensation in the circumstances). Exclusive remedies provisions exclude the ability of an Owner to claim common law damages in the event the liquidated damages regime is declared unenforceable, thereby restricting the Owner’s remedies for delay or underperformance to liquidated damages. If an exclusive remedies clause is inserted, a further question to be determined is to what extent common law damages are unavailable, ie if the clause excludes all common law remedies or only those provisions for which liquidated damages are available. It is clear that whether the terms of a contract constitute a codification of the rights and liabilities of the parties so as to exclude common law rights to damages depends on the construction of each individual contract: Turner Corporation Ltd (Receiver & Manager Appointed) v Austotel Pty Ltd. 7 It is well established that if a party’s common law right to sue for damages for breach of contract is to be removed contractually, it must be done by clear words.8 Courts in both England and Australia have held that clear wording may remove the common law right to damages. This view has been followed in a number of cases.9 In Baese Pty Ltd v RA Bracken Building Pty Ltd10 (Baese), Giles J stated that: “…it would require clear words…before it was held that a liquidated damages clause was the entirety of the proprietor’s rights, because the proprietor would be exposed to being left with no entitlement at all to damages for delay if by reason of his own contribution thereto he was unable to rely upon the liquidated damages clause.”11 This position has arguably been broadened by Australian courts, so that “clear words” does not necessarily mean “express words.” In Turner Corporation Ltd (Receiver and Manager Appointed) v Austotel Pty Ltd12 Cole J held that a party’s rights to common law damages do not need to be excluded by express words; a general intention, surmised from the terms of the contract more generally, can be sufficient: If on the proper construction of the contract as a whole, it can be said that a party has surrendered its common law rights to damages, that construction must be given effect to, notwithstanding absence of express words surrendering the common law rights to damages.13 7 (1994) 13 BCL 378. 8 H W Nevill (Sunblest) v William Press & Sun (1981) 20 BLR 78, 88; Baese Pty Ltd v R A Bracken (1990) 6 BCL 137. 9 See, eg, Photo Production Ltd v Securicor Transport Ltd [1980] AC 827 (Lord Diplock); Hancock v Brazier (Anerley) Limited (1966) 1 WLR 1317; Billyack v Leyland Construction Co Ltd (1968) 1 WLR 471; H W Nevill (Sunblest) v William Press & Sun (1981) 20 BLR 78; Baese Pty Ltd v RA Bracken Building Pty Ltd (1990) 6 BCL 137. 10 (1990) 6 BCL 137. 11 Ibid, 142. 12 (1994) 13 BCL 378. 13 Turner Corporation Ltd (Receiver and Manager Appointed) v Austotel Pty Ltd (1994) 13 BCL 378, [36] (Cole J). Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 22 This is an important and controversial statement of principle, as it suggests that if, on the structure of the contract as a whole, it appears that a party has surrendered its rights to common law damages by the insertion of a particularly comprehensive exclusive remedies clause, that party will have no remedies other than those specifically and particularly stated in the Contract. In Temloc Limited v Errill14 it was held that the words “Nil” in a damages annexure was evidence that the parties intended no liability for either liquidated or unliquidated damages.15 Nourse LJ noted that: “I think it clear, both as a matter of construction and as one of common sense, that if…the parties complete the relevant part of the Appendix…then that constitutes an exhaustive agreement as to the damages which are or are not to be payable by the Contractor in the event of his failure to complete the works on time.”16 These cases suggest that the inclusion of an exclusive remedies clause, then, is a step that can have extremely significant consequences. The effect of an exclusion of common law damages Therefore, while the insertion of an exclusive remedies clause will prevent the Owner from claiming common law damages for delay or underperformance in the event that the liquidated damages are declared invalid, it may have far reaching effects on other clauses of the Contract. A typical comprehensive exclusive remedies clause is as follows: The Owner and the Contractor agree that their respective rights, obligations and liabilities as provided for in the Contract shall be exhaustive of the rights, obligations and liabilities of each of them to the other arising out of, under or in connection with the Contract or the Works, whether such rights, obligations and liabilities arise in respect or in consequence of a breach of contract or of statutory duty or a tortious or negligent act or omission which gives rise to a remedy at common law. Accordingly, except as expressly provided for in the Contract, neither party shall be obligated or liable to the other in respect of any damages or losses suffered by the other which arise out of, under or in connection with the Contract or the Works, whether by reason or in consequence of any breach of contract or of statutory duty or tortious or negligent act or omission. The effect of this clause would considerably affect the Owner’s ability to recover. The final sentence is particularly comprehensive, as it provides that, other than those clauses in the contract for which a remedy is specifically provided for, the Owner would not be able to recover damages from the Contractor for breaches of the EPC Contract or for negligence. It follows that, if there has been a failure by the Contractor to satisfy a contractual obligation, or if the Contractor has been negligent under the contract, then unless the Owner can point to a specific and express remedy under the Contract for such breach or negligence, it would be left without a remedy. An EPC Contract will typically provide specific remedies in the form of liquidated damages for delay and underperformance of the project. Delay and underperformance are only two issues, however, for which an Owner will require contractual compliance. There will be numerous other Contractor obligations under the EPC Contract with which the Owner will require compliance, and for which a remedy should be available in the event of non-compliance or breach. If a comprehensive exclusive remedies clause is inserted, the Contractor may be able to breach numerous provisions of the EPC Contract, or behave negligently in respect of certain conduct, without consequence. 14 [1987] 39 BLR 30. 15 See also CS Phillips Pty Ltd and Anor v Baulderstone Hornibrook Pty Ltd [1994] 30 NSWSC 185 (26 October 1994). 16 [1987] 39 BLR 30, 39. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 23 For example, consider the scenario under an EPC Contract in which the Contractor has brought the project to practical completion/commercial operation and the liquidated damages regime is no longer required. After commercial operation, there remain various opportunities and possibilities for breach. One example is the Contractor’s failure to provide spare parts in accordance with the terms of the EPC Contract. The exclusive remedies clause may have the effect of preventing the Owner from claiming common law remedies for breaches of other provisions of the contract in such a situation. Another example is a breach of the Contractor’s warranty that the Works will be fit for the purpose reasonably inferable from the contract. Proposed solutions One option is for an Owner to accept the Contractor’s exclusive remedies clause, but carefully to elaborate those clauses of the contract for which a remedy is required in the event of breach. These express remedies could then be specifically included in the contract and could operate alongside the exclusive remedies clause. However, in our view, such a strategy is risky, because the Owner would be required to identify all potential breaches of the EPC Contract, and also to consider which remedies should be expressly identified to deal with such breaches. In our view, it is not possible to envisage the different ways in which a Contractor may breach its contractual obligations, and the consequences which the Owner may suffer as a result of the breach. The preferable solution is to argue strongly against the inclusion of an exclusive remedies clause, thereby ensuring maximum latitude to claim for damages at law if the liquidated damages regime is for some reason declared unenforceable. Failing this approach, the other option is to include a “code of rights” provision in the EPC Contract, providing that, except where express remedies are specifically provided under the contract (for example, provisions providing for liquidated damages), each party will be able to claim common law damages for breaches of the contract. The operation of the Prevention Principle Rationale There are various rationales for the existence of the Prevention Principle. These have been variously suggested as:  the principle that a party should not be able to recover from damages for what that same party has caused  an implied term or implied supplemental contract17  waiver or estoppels18  unjust enrichment. Others have suggested that there is in fact no coherent overarching rationale for the Prevention Principle or that it may be regarded as a particular manifestation of the obligation to cooperate implied as a matter of law in all contracts (see Secured Income Real Estate (Australia) Ltd v St Martins Investments Pty Ltd (1979) 144 CLR 596, 607 (Mason J) and Spires Earthworks Pty Ltd v Landtec Projects Corporation Pty Ltd [No 2] [2012] WASCA 54, [46]). In any case, the fundamental considerations are of fairness and reasonableness.19 17 SBS International Pty Ltd v Venuti Nominees Pty Ltd [2004] SASC 151, [11] (Besanko J). 18 [1987] 39 BLR 30. 19 SMK Cabinets v Hili Modern Electrics [1984] VR 391, 397 (Brooking J). Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 24 Operation The operation of the Prevention Principle will ensure that an Owner will lose its right to claim liquidated damages for delay if that delay was caused by an act of prevention, where there is no extension of time clause which specifically provides for extensions due to acts of prevention. A claim that the Prevention Principle operates to set time at large usually arises in the following circumstances:  where a Contractor alleges that the power to extend time has not been exercised, or has been exercised improperly  where there is no clause under the contract to extend time for the Owner’s act of delay, or where that power cannot be exercised in the circumstances. What acts or omissions of the Owner bring the Prevention Principle into operation? Courts generally have regarded any wrongful act or fault as sufficient to enliven the principle.20 It is not necessary that the act constitutes a breach of contract. The broadest view is that any act of the Owner, regardless of its fault element, is sufficient to engage it. Variations are regarded as acts of prevention for the purposes of the doctrine.21 In considering whether an extension of time clause provides for the granting of extensions of time for Owner caused delay, the extension of time clause will be construed contra proferentem against the Owner. It is established that general or ambiguous words in an extension of time clause, referring to such matters as “events beyond the control of the Owner,” will not entitle the Owner to the benefit of the liquidated damages regime.22 Where the extension of time clause provides specifically for the Owner’s breach, waiver or prevention, the liquidated damages regime will be preserved. As stated by Salmon LJ in Peak Construction (Liverpool) Ltd v McKinney Foundations Ltd: 23 “The liquidated damages and extension of time clauses in printed forms of contract must be construed strictly contra proferentem. If the Employer wishes to recover liquidated damages for failure by the Contractors to complete on time in spite of the fact that some of the delay is due to the Employers’ own fault or breach of contract, then the extension of time clause should provide, expressly or by necessary inference, for an extension on account of such a fault or breach on the part of the Employer.”24 One of the more contentious aspects of this area of law concerns the interaction of conditions precedent to the granting of an extension of time with the operation of the Prevention Principle. The issue is whether the Prevention Principle is subject to an administrative act (such as the provision of notice by the Contractor) or whether it can operate independently of such procedural requirements of particular contracts. Case law on this point remains unsettled in England as there has been no comprehensive consideration of the principle since the decision in Alghussein Establishment v Eton College25. However, the case law in Australia remains divided. In Gaymark v Walter Construction (1999)26 (Gaymark), the contract under dispute provided that a notice of delay was to be given within 14 days of the cause of delay arising. The Supreme Court of the Northern Territory reaffirmed an arbitral award that found that, even though the notice requirements were not complied with by the Contractor, because at least some of the delay was caused by the Employer, the right to claim liquidated damages was lost and time was set at large. Gaymark suggests that the Prevention Principle overrides conditions precedent. This view has been subjected to strong academic criticism.27 Later cases have suggested that conditions precedent must be satisfied before the Prevention Principle can have 20 Ian D Wallace (ed), Hudson’s Building and Engineering Contracts (Sweet & Maxwell, 11th ed, 1994) vol 2, [10-040]. 21 SMK Cabinets v Hili Modern Electrics [1984] VR 391, 397 (Brooking J); SBS International Pty Ltd v Venuti Nominees Pty Ltd [2004] SASC 151, [12]. 22 Wallace, above n 20. 23 (1970) 1 BLR 111. 24 Ibid, 121. 25 [1988] 1 WLR 587. 26 [1999] 16 BCL 449. 27 Ian D Wallace, “Prevention and Liquidated Damages: A Theory Too Far?” (2002) 18 Building and Construction Law 82. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 25 application. Indeed, in Turner Corporation Limited (Receiver and Manager Appointed) v Austotel Pty Ltd28 Cole J stated that the builder could not claim that the act of prevention which would have entitled it to an extension of the time for Practical Completion resulted in its inability to complete by that time, because: “A party to a contract cannot rely upon preventing conduct of the other party where it failed to exercise a contractual right which would have negated the affect [sic] of the preventing conduct.”29 A further question regarding the scope of the Prevention Principle concerns what is actually invalidated by the Owner’s act of prevention. If the Owner causes four days of delay to a program, and the Contractor is 100 days late in delivery of the project, can the Owner recover 96 days of liquidated damages, or is the entire liquidated damages regime invalidated? In such a scenario, what is considered to be a reasonable time to complete? Early authority on this point favoured the view that any act of prevention by the Owner invalidated the entire liquidated damages regime. In Holme v Guppy30 the delay in completion was five weeks; the Owner was responsible for four weeks of delay and the Contractor for one week of delay. The court found that the Owner was not entitled to any liquidated damages due to its act of prevention. In Parle v Leistikow31, the Contractor was responsible for a delay of 21 weeks. The total period of delay was 24 weeks. The Court found that, because there had been an act of prevention by the Owner (albeit only three weeks), the Owner was not entitled to any liquidated damages. In Hudson’s Building and Engineering Contracts, Wallace notes that: “[u]nless there is a sufficiently specific clause, it is not open to the Owner or his A/E [independent engineer] where the contract date has ceased to be applicable, to make out a kind of debtor and creditor account allowing so many days or weeks for delay caused by the Owner and, after crediting that period to the builder, to seek to charge him with damages at the liquidated rate for the remainder.” 32 This view appears to be based on the needs of certainty and predictability, and finds its foundation in the classic case of Peak Construction (Liverpool) Ltd v McKinney Foundations Ltd. 33 More recent authority suggests that the Owner’s delay and the Contractor’s delay could be in some circumstances divisible for the purposes of determining and enforcing liquidated damages, but remains circumspect in light of Peak’s authority. In Rapid Building Group v Ealing Family Housing34 Lloyd LJ remarked that: “…I was somewhat startled to be told in the course of the argument that if any part of the delay was caused by the Employer, no matter how slight, then the liquidated damages clause in the contract…becomes inoperative.”35 “I can well understand how that must necessarily be so in a case in which the delay is indivisible and there is a dispute as to the extent of the Employer’s responsibility for that delay. But where there are, as it were, two separate and distinct periods of delay with two separate causes, and where the dispute relates only to one of those two causes, then it would seem to me just and convenient that the Employer should be able to claim liquidated damages in relation to the other period.” 36 Nevertheless, Lloyd LJ went on to note that “it was common ground before us that that is not a possible view…in the light of the decision of the Court of Appeal in Peak’s case, and therefore I say no more about it.”37 28 Turner Corporation Ltd (Receiver and Manager Appointed) v Austotel Pty Ltd (1994) 13 BCL 378, [11] (Cole J). 29 Ibid. 30 (1838) 3 M&W 387. 31 (1883) 4 LR (NSW) 84. 32 Wallace, above n 20, [10.025]. 33 (1970) 1 BLR 111. 34 (1984) 29 BLR 5. 35 Ibid, 18. 36 Above n 21, cited in Keith Pickervance, ‘ Calculation of a Reasonable Time to Complete When Time is at Large,’ [2006] International Construction Law Review 167, 177. 37 (1984) 29 BLR 5, 19. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 26 In SMK Cabinets v Hili, 38 Brooking J stated that the Employer’s act of prevention served only to prevent the Employer from taking liquidated damages that accrued after the Employer’s breach. 39 While this view has much to commend it, the classic case of Peak remains dominant, and authorities seem to suggest that where an act of prevention goes to part of the delay but not the whole, the entire liquidated damages clause will be invalidated.40 This traditional view has recently been reinforced in SBS International Pty Ltd v Venuti Nominees Pty Ltd, 41 where Besanko J held that, in a situation where delay to the completion date is caused by the Contractor as well as the Principal, it is not open to a court to apply the liquidated damages clause to the delay specifically caused by the Contractor. Besanko J stated that: “In those cases where both Principal and Contractor are responsible for delay, the liquidated damages clause will be held inapplicable unless there is a contractual provision by way of an appropriate extension of time clause which accommodates or deals with the delay caused by the contract of the Principal.”42 To summarise, an Owner will not lose its rights to claim liquidated damages if:  the delay is due wholly or in part to an act of prevention  there is a provision in the contract providing for extensions of time due to acts of prevention  an extension of time has been certified pursuant to the Contract. It is prudent to include a provision permitting the Owner to make an extension of time at its discretion, even where the Contractor has not requested one. Such a provision makes it possible to avoid the situation where a Contractor is entitled to an extension of time due to any act of prevention, but has not applied for one on the basis that it can rely on the Prevention Principle. We suggest that the Contract should provide that a cause of delay entitling the Contractor to an extension of time includes:  any act, omission or default by the Owner, the Owner’s Representative and their agents, employees and contracting counterparties  a Variation, except where that Variation is caused by an act, omission or default of the Contractor or its Sub contractors, agents or employees. The Contract should also include a condition precedent provision with which the Contractor must comply before an extension of time can be granted. 38 [1984] VR 391. 39 Ibid, cited in Keith Pickervance, ‘ Calculation of a Reasonable Time to Complete When Time is at Large,’ [2006] International Construction Law Review 167, 177. 40 Wallace, above n 20. 41 [2004] SASC 151. 42 Ibid, [12] (Besanko J). Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 27 Can the Prevention Principle be contracted out of? The question arises whether the Prevention Principle can be explicitly contracted out of, so that a liquidated damages regime can remain on foot despite the Contractor being prevented due to the Owner delaying the works. As well as providing for extensions of time for acts or omissions of the Owner, our standard EPC Contract attempts to contract out of the Prevention Principle as follows:  Any principle of law or equity (including those which might otherwise entitle the Contractor to relief and the Prevention Principle) which might otherwise cause the Date for Commercial Operation to be set at large and liquidated damages unenforceable, will not apply  For the avoidance of doubt, a delay caused by any act or omission of the Owner or any failure by the Owner or the Owner’s Representative to comply with this Clause [ ] will not cause the Date for Commercial Operation to be set at large  Nothing in Clause [ ].2 will prejudice any right of the Contractor to claim an extension of time under this Clause [ ] or delay costs under [ ] for that delay. While we believe that this clause is valid, and that the Prevention Principle can be contracted out of, we must emphasise that this view has not yet received judicial confirmation. There do not appear to be any cases directly on point. However, general principles of law in related areas may provide guidance in this area. The doctrine of freedom of contract suggests that parties are given considerable latitude in determining the terms of their commercial bargain. In 1993, the Privy Council of the United Kingdom quoted approvingly the view that: “…the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum. It has no place where there is no oppression.”43 See to similar effect Mason and Wilson JJ in AMEV-UDC Finance Ltd v Austin (1986) 162 CLR 170, 190. Generally speaking, “although the principle of freedom of contract rests on the premise that individuals are free to make agreements as they wish, the public interest in freedom of contract can be outweighed by other public policy considerations” (see Australian Securities and Investments Commission v Fortescue Metals Group Ltd [2011] FCAFC 19 at [222]). Providing an agreement does not offend public policy, then it will be enforced in its terms. However, equity may prevent the reliance on contractual provisions where there is demonstrated unconscionable conduct. As yet, there is no judicial consideration of such an approach in relation to reliance upon a clause excluding the Prevention Principle. This approach has found favour in a recent High Court decision relating to penalties.44 Similar sentiment may apply to permit parties to contract out of the Prevention Principle. Exceptions from the doctrine of freedom of contract normally require an element of unconscionability or oppression. In Ringrow Pty Ltd v BP Australia Pty Ltd, the High Court of Australia noted that, ”[e]xceptions from that freedom of contract require good reason to attract judicial intervention to set aside the bargains upon which parties of full capacity have agreed.”45 This authority suggests, by analogy, that the Prevention Principle can be excluded in contracts where the parties have expressly agreed upon their risk allocation in terms of time and money. 43 Philips Hong Kong Ltd v The Attorney General of Hong Kong (1993) 61 BLR 49, 58. 44 Ringrow Pty Ltd v BP Australia Pty Ltd (2005) 222 ALR 306, 314 (citing AMEV-UDC Finance Ltd v Austin (1986) 162 CLR 170 at 190). 45 (2005) 222 ALR 306, 314. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 28 However, recent developments in the law of penalties suggest a greater willingness of courts to examine the purpose with which certain contractual clauses purport to operate. For example Andrews v ANZ46 states that a clause may be characterised as penal if it operates as a security to ensure that the primary obligation is performed. This differs from the statement in Ringrow Pty Ltd v BP Australia Pty Ltd where the court focused on the element of oppression or unconscionability. Because the Prevention Principle is based on general principles of fairness, it could be argued that a provision in a contract allowing an Owner to recover liquidated damages as a result of its own delay may be viewed by a court as unconscionable. Indeed, a court may be inclined to ignore a provision which attempts to contract out of the Prevention Principle, and may instead regard such an attempt as a way of bypassing equitable principles on which the principle is built. Similarly, it may be argued a provision which attempts to exclude the operation of the Prevention Principle may sound in a claim for restitution through the principle of unjust enrichment. An attempt to contract out of the Prevention Principle may lead a court to conclude that the Owner, by causing a delay that does not invalidate the liquidated damages regime, is thereby unjustly enriched. However, it is submitted that this view would not be considered persuasive. First, it is submitted that the Prevention Principle is not a fundamental equitable principle, equivalent to established equitable principles. The more sound view is that the Prevention Principle could be contracted out of, subject to the absence of oppression or disadvantage – in which case, the doctrine of unconscionability may apply to impose an equitable remedy. Secondly, a restitutionary claim would be unlikely to succeed based on the exclusion of the Prevention Principle. A claim that the exclusion of a clause, mutually agreed to by the parties (in most cases we presume a valid contract exists between the Owner and the Contractor in relation to the provision of the benefits), could be sufficient to unjustly enrich one party, to the detriment of another, would be highly unusual and an extension of restitutionary principle beyond currently elaborated boundaries. Consequential loss Introduction Contractors often attempt to limit their liability by attempting to exclude all “consequential loss” from liability, or by explicitly excluding certain heads of loss under the construction contract. It is common practice in standard form EPC Contracts to refer to both “indirect” and “consequential” loss or damage in exclusion of liability clauses. Under Australian law, the view had been that there was no legal difference between the words “indirect” and “consequential” in exclusion of liability clauses, until relatively recently. However, case law from Victoria that is likely to be applied in other Australian jurisdictions has now held that consequential loss has a broader meaning than previously assumed. The following explains this change and how parties should interpret these words in commercial negotiations. Under English law, the distinction between indirect and consequential loss, and direct loss, is less certain. 46 Andrews v Australian and New Zealand Banking Group Ltd (2012) 247 CLR 205. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 29 The scope of indirect or consequential loss or damage Position under English law The well-known English case of Hadley v Baxendale 43provides that where a party to a contract is in breach, the damages to which the other party is entitled falls under two limbs, namely, damages such as may fairly and reasonably be considered:  to arise naturally, ie according to the usual course of things, from such a breach of contract (often referred to as direct loss or damage) (first limb)  to be in the contemplation of both parties, at the time they made the contract, as the probable result of the breach of contract (often referred to as indirect loss or damage) (second limb). Under English law, the term “consequential” is confined to the second limb of the rule in Hadley v Baxendale. On this view, the term “indirect or consequential loss or damage” would not include any loss that arises naturally upon the breach, but would include loss or damage that was in the contemplation of both parties, at the time the contract was made, as the probable result of its breach. Under English law, in determining whether a loss is direct or indirect, it has been held that the enquiry is whether the losses arise naturally and in the ordinary course of things.44 English case law has considered which types of loss are typically seen as direct and which are considered indirect or consequential. It is important to emphasise that the classification of loss is often dependent on the specific factual scenarios and contractual provisions at issue, and in practice it is often difficult to determine whether a loss falls within the first or second limb of Hadley v Baxendale. However, the following types of losses have frequently been considered direct loss by courts:  loss of profits  loss of revenue  loss of opportunity  increased expenses or wasted expenditure. Position under Australian law The Australian courts have previously supported the above English view of indirect or consequential loss or damage as loss or damage that was in the contemplation of both parties at the time the contract was made, as the probable result of the breach. However, in the case of Environmental Systems Pty Ltd v Peerless Holdings Pty Ltd45 (Peerless), the Victorian Court of Appeal moved away from the “second limb test” and decided that the term “consequential loss” should be given its ordinary and natural meaning as would be conceded by ordinary reasonable business persons. In applying this principle, the court drew a distinction between:  loss that every plaintiff in a like situation will suffer (normal loss)  anything beyond the normal measure, such as profits lost or expenses incurred through breach (consequential loss). Peerless was highly influential in the recent decision of Alstom Ltd v Yokogawa Australia Pty Ltd (No 746 (Alstom), where the Supreme Court of South Australia considered a clause excluding Yokogawa’s liability as sub contractor for “any indirect, economic or consequential loss whatsoever”. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 30 The terms of the contract required the sub contractor to pay damages if it did not complete the works on time or if the works did not meet the performance tests. Alstom made claims against the sub contractor and sought compensation in relation to breaches of these obligations, asserting that the breaches had resulted in losses that flowed naturally from each breach, and therefore were within the first limb of Hadley v Baxendale. The sub contractor rejected this assertion and relied upon the exclusion clause, submitting that it should be read more generally to include losses that occurred as a consequence of breach of contract. The Court considered these claims, and held that the losses claimed by Alstom fell within the first limb, but the breadth of the exclusion clause meant that the sub contractor was not liable for damages occurring as a consequence of any breaches of contract: “The expression “indirect … or consequential loss” appears, in this case, as part of a freestanding and powerfully expressed exclusion clause. It is not affected by the immediate presence of any concession as to liability which it might qualify, although it must be read against the background of the qualified exposure of [the sub contractor] to the exclusive remedies of Liquidated Damages and reimbursement of Performance Guarantee Payments. The Article in question was intended to operate in respect of potential liability for loss incurred by Alstom, which was caused by a breach of contract by [the sub contractor] in circumstances other than those giving rise to the payment of Liquidated Damages and reimbursement of Performance Guarantee Payments. The words must be given their ordinary and natural meaning. In those circumstances any loss consequential or following, immediate or eventual, flowing from a breach of contract by [the sub contractor] is excluded from recovery by Alstom.”47 In so doing, the Court noted Peerless was the preferred precedent over the English cases. In 2013, the West Australian Supreme Court decision of Regional Power Corporation v Pacific Hydro Group Two Pty Ltd (No 2)48 (Regional Power) rejected both the English approach to the construction of the term “consequential loss” as falling under the second limb of Hadley v Baxendale, and the view adopted by Peerless. Regional Power concerned a PPA entered into between Regional Power Corporation (SECWA) and Pacific Hydro Pty Ltd for the supply of electricity. The power station suffered an outage resulting in flooding which lead to the power station being inoperative for two months. Resultantly, SECWA claimed damages for breach of the PPA consisting of costs relating to the hiring of replacement diesel generators, cranes and fuel required to run the extra generators; and wages, travel, accommodation and meal expenses of the additional Operators required during that period. Pacific Hydro argued that the damages claimed by SECWA were indirect or consequential losses and accordingly were excluded from recovery by the following clause 26.1: Neither the Project Entity nor SECWA shall be liable to the other party in contract, tort, warranty, strict liability, or any other legal theory for any indirect, consequential, incidental, punitive or exemplary damages or loss of profits. The Court rejected both the Hadley v Baxendale and Peerless positions in favour of the well settled construction approach by the High Court in Darlington Futures, stating: “To reject the rigid construction approach towards the term “consequential loss” predicated upon a conceptual inappropriateness of invoking the Hadley v Baxendale dichotomy as to remoteness of loss, only then to replace that approach by a rigid touchstone of the “normal measure of damages” and which always automatically eliminates profits lost and expenses incurred, would pose equivalent conceptual difficulties. Accordingly, I doubt whether the [93] observations in Environmental Systems were intended to carry any general applicability towards establishing a rigid new construction principle for limitation clauses going much beyond the presenting circumstances of that case. 47 (1854) 9 Ex 341. 48 Peerless Holdings Pty Ltd v Environmental Systems Pty Ltd [2006] VSC 194. See also Hotel Services Ltd v Hilton International Hotels (UK) Ltd [2000] 1 All ER (Comm) 750. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 31 The natural and ordinary meaning of the words of cl 26.1, begins with these words themselves, assessed in their place within the context of the PPA as a whole. That, on my assessment, is the correct approach to a limitation or exclusion clause required by Darlington Futures Ltd v Delco Australia Pty Ltd, as recently applied by the Western Australia Court of Appeal in Electricity Generation Corporation t/as Verve Energy v Woodside Energy Ltd [38], [42] (McLure P), [138], [140] (Murphy JA)… Construing 26.1 within the PPA as a whole, the court should not be artificially fettered towards assessing the character of an economic loss by rather vague criteria of whether or not the loss arose ”in the ordinary course of things”. Nor should the court be oriented from the start towards trying to determine if a claimed loss falls under the equally porous concept of “normal measure of damage.”50 Effect on drafting In summary, there are now three different approaches to the meaning of the words “indirect or consequential” when used in an exclusion clause (or limitation clause, in the instance of Regional Power):  the English approach, where the words are construed as a reference to damages resulting from special circumstances under which the contract was made communicated by one party to the other  the Peerless/Alstom approach, where the word “consequential” was said to refer to everything beyond the normal measure of damages, such as profits lost or expenses incurred through breach  the Regional Power approach, where the words are said to exclude losses that are in some way less direct and more removed when considered in the context of the transaction at hand. Contracts governed by Australian law Darlington Futures holds that limitation (or exclusion) clauses excluding certain categories of loss and damage must be interpreted according to their natural and ordinary meaning, read in the light of the contract as a whole, thereby giving due weight to the context in which the clause appears including the nature and object of the contract. This principle of interpretation must be applied by courts in Australia. The problem however is whilst the Darlington Futures decision confirms the contextual, commercial approach to the interpretation of commercial contracts in Australia, there is potential for significant differences in what would, in a given situation, constitute the ordinary and natural meaning of “consequential loss”, given the clear requirement that losses claimed be interpreted in context of the contract in question. This is highlighted by the recent conflicting principles as to the scope of “consequential loss” taken by the states below (noting the question is yet to be considered in Queensland, Tasmania, the Australian Capital Territory or Northern Territory):  Victoria, New South Wales and South Australia: “consequential loss” is what an ordinary reasonable business person would consider consequential loss ie everything beyond the normal measure of loss (loss that every plaintiff in a like situation will suffer). Lost profits and expenses incurred as a result of breach were given as two examples of consequential losses: Peerless; Alstom  Western Australia: “consequential loss” is given its natural and ordinary meaning, read in light of the contract as a whole (ie rejecting the above position and reinforcing the High Court position): Regional Power. As a result of these decisions, the term “indirect or consequential” should no longer be interpreted as confined to the second limb of the rule in Hadley v Baxendale. Instead, any exclusion of indirect or consequential loss should be understood as also excluding some categories of loss that would otherwise be considered to fall under 49 Peerless Holdings Pty Ltd v Environmental Systems Pty Ltd [2006] VSC 194, [96-97; 116]; Millars Machine Co Ltd v David Way & Son (1934) 40 Com Cas 204; Croudace Construction Ltd v Cawoods Concrete Products [1978] 8 BLR 20. 50 GEC Alsthom Australia v City of Sunshine [1996] 170 FC 1 (20 February 1996); Aquatec-Maxcon Pty Ltd v Barwon Region Water Authority (No 2) [2006] VSC 117, [103]. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 32 the first limb of Hadley v Baxendale; to be determined by construing the clause according to its natural and ordinary meaning, read in the light of the contract as a whole. Contracts governed by English law In contracts governed by English law, the following consequential loss clause should be included: Without prejudice to the Employer’s right to recover liquidated damages or damages at law for delay or underperformance under clauses 24 and 25 or where otherwise stated in the contract, neither party is liable to the other under the contract, law of tort, including negligence, statute, inequity or otherwise for any kind of indirect or consequential loss or damage including, loss of use, loss of profit, loss of production or business interruption which is connected with any claim arising under the contract or the subject matter of the contract. The wording of this clause permits the Employer a certain degree of latitude. In cases where the Contractor has caused loss, the Employer can argue that because of the use of the word “including”, the expressly listed types of loss are in fact forms of direct loss that are thereby recoverable. This approach has authority to commend it. In Pegler Ltd v Wang (UK) Ltd,51 the relevant exclusion clause provided that: “Wang shall not in any event be liable for any indirect, special or consequential loss, howsoever arising (including but not limited to loss of anticipated profits or of data) in connection with or arising out of the supply, functioning or use of the hardware, the software or the services…”53 Despite the use of the word “including”, the court held that the clause only excluded losses falling under the second limb of Hadley v Baxendale. It was noted by Judge Bowsher QC that: “The reference by the words in brackets to loss of anticipated profits does not mean that the exclusion effected by this clause includes all loss of profits: it is plain from the context that only loss of profits which are of the character of indirect, special or consequential loss are referred to.”54 It is certainly arguable that a court would adopt the same approach when considering our proposed clause, so that, for example, losses of profits that could be classified as direct could be recoverable by the Employer. Courts have interpreted similar consequential loss clauses in ways that emphasise the difference between those losses commonly thought to be direct and other forms of indirect loss. In BHP Petroleum Ltd v British Steel PLC, 5556 Rix J considered the following consequential loss clause: “Neither the supplier nor the purchaser shall bear any liability to the other…for loss of production, loss of profits, loss of business or any other indirect losses or consequential damages arising during and/or as a result of the performance or non-performance of this contract.” Rix J interpreted this clause quite radically by construing the clause to read “for loss of production, loss of profits, loss of business or indirect or consequential damages of any other kind”, as his Honour found that the express heads of loss could not be construed as forms of indirect or consequential loss. However, Rix J’s interpretation of this clause is somewhat unusual, albeit in favour of the Employer. We favour the use of our 51 [1999] 1 Lloyd’s Rep 387. 52 (1986) 161 CLR 500. 53 [2013] WASC 356. 54 (2008) 19 VR 358. 55 [2013] WASC 356, [96-97, 116]. 56 MWH Australia Pty Ltd v Wynton Stone Australia Pty Ltd (in liq) (2010) 31 VR 575, [87]-[88]; Glenmont Investments Pty Ltd v O’Loughlin & Ors (2000) 79 SASR 185, [247]-[273]. Exclusive remedies, liquidated damages, the Prevention Principle, consequential loss and implied warranties PwC 33 clause, which is less radical and, given the authority in Pegler v Wang, would permit the Employer to argue persuasively for recovery of those losses that could be classified as direct. Given the unclear position under Australian law, parties must also ensure that an exclusion of liability clause is carefully drafted. Importantly, the clause should set out clearly and exhaustively expressed in detail those losses which are intended to be categorised as consequential. Where presented with a clause excluding liability for consequential loss, Owners must expressly state the categories of loss for which the Contractor will be liable. This essentially means that Owners will need to include a definition of Direct Loss which would identify losses that are within the contemplation of the parties, eg in a project financing of a power or process plant project this should include loss of revenue under a corresponding off take agreement. Clearly this will be difficult to negotiate, but this should be the starting position. Exclusion of implied warranties Contractors often propose to delete reference to warranties implied by law. A general exclusion may be expressed as follows: The parties agree that the warranties in this clause and any other warranties expressed elsewhere in the Contract are the limit of the Contractor’s warranties and are to the exclusion of any implied warranties at law. Despite such a clause, certain warranties cannot be excluded by contractual agreement. For example, in Australia it is impossible to contract out of certain provisions of the Australian Consumer Law. Those provisions that are most applicable to EPC projects, such as section 18 on misleading or deceptive conduct, cannot be validly excluded. Further, a ‘fitness for purpose’ warranty will be implied despite a Contractor’s desire to exclude it. Nevertheless, we would agree to the inclusion of such a clause excluding implied warranties only if the list of express warranties is comprehensive. These warranties will usually be project specific, but Owners should take great care to ensure that their ability to recover is protected. PwC 34 3 Position paper on performance liquidated damages – Power projects Introduction The interaction between the performance and completion conditions in an Engineering, Procurement and Construction (EPC) contract and the provisions for Performance Liquidated Damages (PLDs) payable under it will vary depending on a number of circumstances, including the size, nature and complexity of the project. This paper outlines two suites of clauses that may be included in an EPC Contract to accommodate these situations. They are drafted for power projects, but may be relevant to other sectors, such as oil and gas and for process plant projects. Solar and wind projects will require a different regime with more of a focus on post commercial operation testing, ie a production guarantee mechanism. Your project requirements Overview This section addresses the benefits and utility of two different PLDs regimes, before discussing some of the project characteristics that might render one regime more or less suitable to your project. Features of the simple regime The simple regime uses a two-stage completion process whereby the Contractor does not have the ability to access the facility after the Owner assumes care, custody and control for the purposes of improving performance. Sample clauses illustrating this approach are contained in Appendix 1 (Simple regime clauses). This regime is appropriate where:  the planned operation of the facility is such that it is not feasible for the Owner to allow the Contractor any significant period of time beyond the date for commercial operation in which to make modifications and retest the facility  provided the minimum performance guarantees are met, the Owner allows the Contractor to choose to retain care, custody and control so that it can improve the results of the guarantee tests whilst paying Delay Liquidated Damages (DLDs). Features of the detailed regime The detailed regime uses a three-stage completion process, incorporating a period of time after the Owner assumes control of the facility in which the Contractor may, with the Owner’s approval, attempt to improve the performance of the facility whilst paying DLDs. This regime is appropriate where:  the Owner prefers to take possession of the facility and begin generating electricity as soon as commercial operation is achieved (effectively, in certain circumstances, as soon as the minimum performance guarantees are met)  it is viable, even after the Owner has assumed the care, custody and control of the facility, for the Owner to allow the Contractor access to attempt to improve performance whilst paying DLDs. Position paper on performance liquidated damages – Power projects PwC 35 Features of your project The following questions may help decide which regime is more appropriate. Are you building a baseload facility or a peaking facility? Both regimes have been drafted to apply to a baseload facility, but each can easily be tailored for a peaking facility. However, given that a peaking facility only operates during periods of high demand, it may be possible for the Owner to grant the Contractor access to the facility (after the Owner takes over the facility) without suffering undue inconvenience or expense (through lost operation time). This may make the detailed regime more suitable to a peaking facility, especially if DLDs will run during any period that the Contractor takes the facility out of service (even if not required to generate electricity during that period). Is there an inflexible deadline for you to begin operating the facility? If there is an inflexible deadline by which you must begin operating the facility (such as a contractual obligation to begin selling electricity)1 the detailed regime may be the more appropriate option. Under the detailed regime, the Owner is better placed to take over the facility on or before the date for commercial operation (provided that the minimum performance guarantees are met), and later allow, at the Owner’s discretion and convenience, the Contractor to attempt to improve the performance of the facility (during periods of low demand). The Contractor has an incentive during these periods to bring the performance of the facility to the highest possible level in order to minimise its PLDs liability. Accordingly, the Owner achieves the highest standard of plant performance without undue disruption to its operation of the facility. Is the performance of the facility your highest priority? If there is some flexibility in the date by which you must begin operating the facility, and the first priority is to ensure that the facility achieves the highest possible standard of performance, the simple regime may be more suitable. This regime requires commercial operation (and, in this regime, the point at which the Contractor is no longer permitted to continue work on the project) to be deferred as long as is required to meet the performance guarantees (limited only by the Contractor reaching the aggregate limit for DLDs). Under this arrangement, the Owner does not take control of the facility until the performance guarantees are met or DLDs cap out. This means the facility will be at the maximum possible level of performance by the time the Owner begins operating. Simple regime This section will analyse in detail the simple regime. As discussed above, it employs a two-stage completion process and does not permit the Contractor any opportunity to improve the facility’s performance after the Owner assumes care, custody and control. Refer to Appendix 1 (Simple regime clauses) for the sample clauses illustrating the simple regime. Preliminary steps The simple regime requires several steps to be completed prior to commercial operation: mechanical completion, precommissioning, and commissioning.2 1 The performance regime for a project may also be influenced by the terms of any third party offtake agreements, particularly back-to-back arrangements for liquidated damages and other performance guarantees. 2 Note that there will be different commissioning and testing requirements depending on the characteristics of the facility in question, including, for a gasfired plant, whether it is single or combined cycle, and otherwise whether there are various units, staged completion or synchronisation issues. Position paper on performance liquidated damages – Power projects PwC 36 Mechanical completion Mechanical completion is the stage at which the facility has been completed mechanically and structurally, within the requirements of the contract, such that the facility is able to be started. The Contractor must notify the Owner’s representative when it is satisfied that the facility has reached mechanical completion. The Owner’s representative must then either:  issue a certificate of mechanical completion  notify the Contractor of any deficiencies in the facility preventing the issue of a certificate of mechanical completion. The Contractor must correct any defects and reapply for a certificate of mechanical completion. This procedure is repeated until the certificate of mechanical completion is issued. Precommissioning and commissioning Commissioning is the stage at which the facility is operated by the Contractor in a limited way for the purpose of preparing the facility for operation and for the performance tests necessary to establish commercial operation. Prior to commissioning, the Contractor must comply with certain procedures set by the Owner (as specified in the project documentation). After these precommissioning procedures are completed, the Contractor may begin commissioning. Commercial operation The simple regime then sets out the steps necessary for the facility to be placed into commercial operation. Broadly, commercial operation is the point at which the facility can be operated reliably, safely and legally under the conditions it is normally expected to operate within and:  the environmental guarantees (that is, emissions and noise) have been met  the performance guarantees have been met3 or PLDs paid for any shortfall in meeting such guarantees. It is permissible for some minor items to remain outstanding at the point of commercial operation, provided that the Contractor undertakes a programme for their proposed completion and they do not impact on the safe and efficient performance of the facility. The steps required for achieving commercial operation are as follows. Performance tests After commissioning the facility, and when the Contractor is satisfied that all requirements for commercial operation have been met, it must notify the Owner’s representative that the facility has achieved commercial operation. If, during the performance tests, the performance guarantees are not met, the Contractor must make such changes, modifications and/or additions to the facility as are necessary to meet the performance guarantees. On completion of these modifications, the Contractor must notify the Owner and continue to repeat the tests until the performance guarantees are met. This process will ordinarily continue until DLDs cap out. However, at any time between the date for commercial operation and the date of DLDs capping out, either the Contractor or the Owner may elect to stop further work on the facility. Where such an election is made, the Contractor pays PLDs in consideration of its failure to satisfy the performance guarantees. 3 For example, both heat rate and output. Position paper on performance liquidated damages – Power projects PwC 37 Certificate of commercial operation On successful completion of the performance tests, the Contractor must notify the Owner’s representative that, in the Contractor’s opinion, the facility has reached commercial operation. The Owner’s representative must then either:  issue a certificate of commercial operation  notify the Contractor of any defects preventing the facility from reaching commercial operation. The Contractor must remedy any defects and repeat the performance tests until the Owner’s representative issues a certificate of commercial operation. The Contractor hands over care, custody and control of the facility when the Owner issues a certificate of commercial operation. Final completion The last stage in the simple regime is final completion, which is the point when:  commercial operation has been achieved  all defects and deficiencies have been remedied by the Contractor  the defects liability period has expired. The process for achieving final completion is as follows. Notification The Contractor must notify the Owner’s representative that the facility has reached the stage of final completion. Certificate of final completion The Owner’s representative must then either:  issue a certificate of final completion  notify the Contractor of any outstanding defects that must be remedied before final completion can be achieved. The Contractor must remedy any defects and repeat the notification procedure until the Owner issues a certificate of final completion. PLDS4 Assuming that neither party exercises their right to terminate, PLDs are payable by the Contractor upon the earlier of:  either party electing to stop further modifications by the Contractor, provided that the date for commercial operation has passed  DLDs capping out. 4 Depending on the nature of the project and other commercial considerations, PLDs may not always be suitable compensation for a failure to achieve the minimum performance guarantees. Other options available to the Owner can include a right to reject the facility and buy-down (at a price determined by a pre-agreed valuation formula) or the Owner may wish to terminate the contract and engage others to complete the facility at the Contractor’s cost. Position paper on performance liquidated damages – Power projects PwC 38 For the purposes of assessing PLDs, commercial operation will be deemed at the point at which DLDs cap out. (Note that this discussion does not take into account any PLDs that may arise because of a failure to meet the availability guarantee). PLDs may be payable in the following four scenarios. Opt-out election; minimum performance guarantees not met; performance guarantees not met This scenario will arise if, at the date for commercial operation, the minimum performance guarantees have not been met. The Contractor is obliged to continue retesting until DLDs cap out, unless, as in this scenario, either the Contractor or the Owner exercises its rights to halt further work on the facility and have the Contractor pay PLDs. At the point of that election, the minimum performance guarantees will remain unsatisfied, meaning that the performance guarantees have also not been satisfied. Liability to pay PLDs will arise for the Contractor’s failure to meet the minimum performance guarantees and to meet the performance guarantees.5 Opt-out election; minimum performance guarantees met; performance guarantees not met This situation will arise as in the paragraph above, except that at the date for commercial operation the minimum performance guarantees may or may not have been met, and, in any event, at the point of the Contractor or the Owner electing not to continue modification, the Contractor will have achieved the minimum performance guarantees. Accordingly, the Contractor’s liability to pay PLDs will arise only in respect of the failure to meet the performance guarantees. DLDs cap out; minimum performance guarantees not met; performance guarantees not met This scenario will arise where the Contractor has failed to meet the minimum performance guarantees during the performance tests and continued modification and retesting by the Contractor fails to improve the facility for it to meet the minimum performance guarantees before DLDs cap out. Liability to pay PLDs will arise for the Contractor’s failure to meet the minimum performance guarantees and to meet the performance guarantees. DLDs cap out; minimum performance guarantees met; performance guarantees not met This scenario will arise where the performance tests demonstrate that the minimum performance guarantees have been met, but the performance guarantees have not. The Contractor is accordingly obliged to continue modifications and retesting. PLDs will become payable if, at the point DLDs cap out, the Contractor has failed to improve performance to meet the performance guarantees. 5 Note that there may be differing rates of PLDs. PLDs for a failure to meet the Minimum Performance Guarantees may be higher than those payable for a failure to achieve the Performance Guarantees. Position paper on performance liquidated damages – Power projects PwC 39 Detailed regime This section will discuss the operation and function of the detailed regime. As stated earlier, the detailed regime establishes a three-stage completion process, incorporating a period of time in which the Contractor may, with the Owner’s approval, attempt to improve the performance of the facility. This period of time occurs after the Owner certifies commercial operation and takes control of the facility. Sample clauses illustrating the detailed regime are included in Appendix 2 (Detailed regime clauses). Preliminary steps Under the detailed regime, several steps must be completed to achieve commercial operation. Mechanical completion, precommissioning and commissioning Under the detailed regime, the concepts of mechanical completion, precommissioning and commissioning are identical to those under the simple regime (see above). Commercial operation After mechanical completion, precommissioning and commissioning, the detailed regime then specifies certain steps that are required for the facility to be placed into commercial operation. Similar to the notion of commercial operation in the simple regime, commercial operation is the point at which the facility can be operated reliably, safely and legally under the conditions it is normally expected to operate within and:  the environmental guarantees have been met  the minimum performance guarantees have been satisfied  One of: – the performance guarantees have been met – the Contractor has paid PLDs in consideration of its failure to meet the performance guarantees – the Contractor has elected to utilise the subsequent testing period in an attempt to meet the performance guarantees post-commercial operation and has given security for the PLDs that would otherwise be payable. It is permissible for some minor items to remain outstanding at the point of commercial operation, provided that the Contractor provides a programme for their proposed completion. After the preliminary steps are completed, the procedures that must be followed to achieve commercial operation are as follows: Performance tests Once the Contractor is satisfied that all requirements for commercial operation have been met, the Contractor must notify the Owner’s representative. The performance tests must then take place. If, after the performance tests are completed, the minimum performance guarantees have not been met, the Contractor must, at its own expense, make such changes, modifications or additions as may be required to meet the minimum performance guarantees. When the modifications are completed, the Contractor must notify the Owner and continue to repeat the overall performance test until the minimum performance guarantees are met. Position paper on performance liquidated damages – Power projects PwC 40 Otherwise, if, after the performance tests are completed, the:  performance guarantees have been met  minimum performance guarantees have been met and either: – the Contractor elects to pay PLDs in lieu of meeting the performance guarantees – if DLDs have not capped out, the Contractor elects to give security and exercise its rights to utilise the subsequent testing period, the Contractor must notify the Owner’s representative that the facility has reached commercial operation. Certificate of commercial operation The Owner must either:  issue a certificate of commercial operation (effectively certifying that the minimum performance guarantees have been met)  notify the Contractor of any defects or deficiencies that prevent the facility from reaching commercial operation. The Contractor must remedy any defects and again notify the Owner that the facility is ready for commercial operation. This process must be repeated until the Owner issues a certificate of commercial operation. When the Owner issues the certificate of commercial operation, care, custody and control of the facility is handed to the Owner. Note that the Owner has the discretion to issue a certificate of commercial operation at any time (notwithstanding that the requirements for issuing a certificate of commercial operation have not been met). At this point, if the minimum performance guarantees have been met, but the performance guarantees have not, and the Contractor has elected to pay PLDs rather than attempt to improve the facility’s performance, the PLDs must be paid. Alternately, if the minimum performance guarantees have been met, but the performance guarantees have not, and the Contractor has provided the Owner with security for the PLDs (in the form of payment or a bank guarantee), the subsequent testing period commences. Subsequent testing period6 The subsequent testing period is a 60-day period after commercial operation in which, if the performance guarantees have not been met and the Contractor elects to utilise the subsequent testing period, the Contractor may request access to the facility to perform modifications and otherwise seek to improve performance (despite the fact that care, custody and control of the facility has passed to the Owner). During the subsequent testing period, the Contractor may at any time:  request the facility to be taken out of service  at its own expense, make changes, modification or additions to the facility in an attempt to meet the performance guarantees  notify the Owner upon completion of any changes or modifications  continue to repeat the overall performance test. 6 During this period, the Contractor is responsible for the cost of fuel, water and all other consumables necessary for the additional testing. Position paper on performance liquidated damages – Power projects PwC 41 The Owner has an absolute discretion to refuse or reschedule the Contractor’s request to take the facility out of service. During periods where the facility is taken out of service, the Contractor assumes sole and absolute responsibility for the care, custody and control of the facility and bears the risk of loss or damage to it. Final commercial operation Where the Contractor has failed to meet the performance guarantees at the point of commercial operation and elects to utilise the subsequent testing period, a further stage of completion is required (Final Commercial Operation). Final Commercial Operation is reached on the earliest of:  the date DLDs cap out  the expiration of the subsequent testing period  the date on which the Owner issues the certificate of final completion. There are two stages to the achievement of Final Commercial Operation. Notification The Contractor must notify the Owner’s representative that it believes the facility has reached Final Commercial Operation. Certification of final commercial operation The Owner’s representative must either:  issue a certificate of Final Commercial Operation  notify the Contractor of any defects preventing the facility from reaching Final Commercial Operation (effectively, any defect causing the facility to no longer satisfy the minimum performance guarantees or another compulsory condition). The Contractor must remedy any defects and again notify the Owner’s representative that the facility has reached Final Commercial Operation. This procedure must be repeated until the Owner’s representative issues a certificate of Final Commercial Operation. Final completion The final completion procedure is identical under both the simple and detailed regimes (see above). PLDs PLDs become payable under the detailed regime at the point of:  if the minimum performance guarantees are not met (and thus commercial operation is not achieved) before DLDs cap outcommercial operation  where the subsequent testing period is utilised, Final Commercial Operation. (Note that this discussion does not take into account any PLDs that may arise because of a failure to meet the availability guarantee.) The following sections set out the PLDs that will be payable in the three possible scenarios. DLDs cap out; minimum performance guarantees not met; performance guarantees not met This scenario will arise either where the Contractor:  does not reach the point of carrying out performance tests on the facility before DLDs cap out and overall performance tests at that point reveal that the minimum performance guarantees have not been met Position paper on performance liquidated damages – Power projects PwC 42  has failed to meet the minimum performance guarantees at the point of the performance tests and continued modification and retesting fails to improve the facility for it to meet the minimum performance guarantees before DLDs cap out. In this case, liability to pay PLDs will arise in respect of the failure both to meet the minimum performance guarantees and to meet the performance guarantees. Commercial operation; minimum performance guarantees met; performance guarantees not met This scenario will arise only where the performance tests demonstrate that the minimum performance guarantees have been met, but the performance guarantees have not been met and the Contractor elects to immediately pay PLDs in consideration of its failure to meet the performance guarantees. PLDs will become payable in this scenario as soon as the Contractor makes such an election. Final commercial operation; minimum performance guarantees met; performance guarantees not met This scenario will arise where the performance tests demonstrate that the minimum performance guarantees have been met, but the performance guarantees have not been met and the Contractor applies for commercial operation and elects to utilise the subsequent testing period. In this scenario, the Contractor must secure its potential PLDs liability (as at commercial operation) by either:  paying the PLDs that would be payable at commercial operation (for the failure to meet the performance guarantees)  providing a bank guarantee to the Owner for the same amount. At the point of Final Commercial Operation, PLDs will crystallise and:  if the Contractor has met the performance guarantees, the money paid or security will be refunded or released, less an offset for the period of reduced performance between commercial operation and Final Commercial Operation  if the Contractor has improved the performance of the facility, but has not met the performance guarantees, a portion of the money paid or security will be refunded or released, proportionate with the increase in performance, less an offset for the period of reduced performance between commercial operation and Final Commercial Operation  if the performance of the facility is the same as or worse than it was at commercial operation, the Owner will retain the PLDs or cash the guarantee and the Contractor will be liable to pay to the Owner an amount equal to the difference between the PLDs now payable for the deficiency in performance and the money or guarantee already given by the Contractor. PwC 43 Appendix 1 Simple regime clauses Precommissioning and commissioning Mechanical completion (a) As soon as the facility, in the opinion of the Contractor, reaches the stage of Mechanical Completion the Contractor must give a notice to the Owner’s representative. (b) The Owner’s representative must, promptly, and no later than five business days after receipt of the Contractor’s notice under clause 1.1(a), either issue a Certificate of Mechanical Completion stating that the facility has reached Mechanical Completion or notify the Contractor of any defects and/or deficiencies. (c) If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct those defects and/or deficiencies and the procedures described in clauses 1.1(a) and (b) must be repeated until the Owner’s representative issues a Certificate of Mechanical Completion. Precommissioning The Contractor must comply with the Owner’s requirements and procedures in relation to Precommissioning as set out in the schedule of technical specification. Commissioning As soon as all works in respect of Precommissioning are completed the Contractor must notify the Owner’s representative in writing that the facility is ready for the commissioning tests. Requirements and procedures The Contractor must comply with the Owner’s requirements and procedures in relation to Commissioning and the performance of the commissioning tests as set out in the schedule of technical specification. Performance tests, commercial operation and final completion Performance tests (a) After the initial testing is completed, and as soon as the facility, in the opinion of the Contractor, satisfies all the requirements for Commercial Operation (other than the passing of the Performance Tests), the Contractor must notify the Owner’s representative in writing that the facility is ready for the Performance Tests. (b) Each Performance Test must be completed at the time and in accordance with the procedures specified in the schedule of tests. (c) The Contractor acknowledges and agrees that, despite any other provision of this contract, no partial or entire use or generation of electricity or occupancy of the site, the Works or the facility as a whole by the Owner, whether prior to, during or after the Performance Tests or otherwise, in any way constitutes an acknowledgment by the Owner that Commercial Operation has occurred, nor does it operate to release the Contractor from any of its warranties, obligations or liabilities under or in connection with this contract. Simple regime clauses PwC 44 Commercial operation (a) As soon as the facility has passed the Performance Tests the Contractor must notify the Owner’s representative in writing that the facility has, in the Contractor’s opinion, reached Commercial Operation. That notice must, if applicable, also include the Contractor’s list of minor outstanding items that in its view meet the requirements of paragraph (k) of the definition of Commercial Operation and a programme for expeditiously completing those minor outstanding items. (b) The Owner’s representative must promptly, and no later than five days after receipt of the Contractor’s notice under clause 2.2(a), either issue a Certificate of Commercial Operation stating the date on which the facility has reached Commercial Operation or notify the Contractor in writing of any defects and/or deficiencies that prevent the facility from achieving Commercial Operation. (c) If the Owner’s representative notifies the Contractor of any such defects and/or deficiencies, the Contractor must then remedy those defects and/or deficiencies and the procedures described in clauses 2.2(a) and (b) must be repeated until the Owner issues a Certificate of Commercial Operation. (d) Upon the issue of the Certificate of Commercial Operation, the Contractor must hand over care, custody and control of the facility to the Owner. (e) Notwithstanding that all the requirements for the issuing of a Certificate of Commercial Operation have not been met, the Owner may at any time, in its absolute, sole and unfettered discretion, issue a Certificate of Commercial Operation. The issue of a Certificate of Commercial Operation in accordance with this clause 2.2(e) will waive the requirement of paragraph (d) of the definition of Commercial Operation but will not operate as an admission that all the other requirements of Commercial Operation have been met, and does not prejudice any of the Owner’s rights, including the right to require the Contractor to satisfy all these requirements, nor does it release the Contractor from any of its warranties, obligations or liabilities under or in connection with this contract. Final completion (a) As soon as the facility, in the opinion of the Contractor, reaches the stage of Final Completion the Contractor must give a written notice to the Owner’s representative. (b) The Owner’s representative must, promptly, and no later than five days after receipt of the Contractor’s notice under clause 2.3(a), either issue a Certificate of Final Completion stating that the facility has reached Final Completion or notify the Contractor in writing of any defects and/or deficiencies that must be remedied before Final Completion can be achieved. (c) If the Owner’s representative notifies the Contractor of any outstanding defects and/or deficiencies, the Contractor must then remedy those defects and/or deficiencies and the procedures described in clauses 2.3(a) and (b) must be repeated until the Owner issues a Certificate of Final Completion. Performance guarantees Performance guarantees (a) The Contractor guarantees that the facility as a whole and all sections thereof will meet the: (i) Performance Guarantees (ii) Environmental Guarantees (iii) as specified in the schedule of performance guarantees and the schedule of tests. (b) The Contractor agrees that the Environmental Guarantees are absolute guarantees, the meeting of which is a condition precedent to achieving Commercial Operation. Simple regime clauses PwC 45 Performance guarantees not met – Retesting If for reasons not attributable to the Owner, either or both of the Performance Guarantees are not met during the same Performance Test, the Contractor must: (a) at its cost and expense make changes, modifications and/or additions to the facility or any part as may be necessary to meet the Performance Guarantees (b) notify the Owner upon completion of the necessary changes, modifications and/or additions (c) subject to the Owner’s rights under clauses 2.2(e) and 3.5 and 3.14, continue to repeat the Performance Test until the Performance Guarantees have been met during the same Performance Test. Minimum performance guarantees not met – PLDs Subject to clause 2.2(e), if for reasons not attributable to the Owner, the Contractor does not meet one or more of the Minimum Performance Guarantees by the date it has incurred or is liable for Delay Liquidated Damages up to the aggregate liability specified in the schedule of delay liquidated damages, the Owner may require the Contractor to pay: (a) if the Minimum Net Electrical Output Performance Guarantee has been met (but the net electrical output performance guarantee has not been met) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages (b) if the Minimum Net Electrical Output Performance Guarantee has not been met: (i) an amount equal to the amount the Contractor would have been liable for if the actual rated net output of the facility was equal to 95.0% of the net electrical output performance guarantee as specified in the schedule of performance liquidated damages (ii) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages. (c) if the Minimum Net Heat Rate Performance Guarantee has been met, (but the net heat rate performance guarantee has not been met) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages (d) if the Minimum Net Heat Rate Performance Guarantee has not been met: (i) an amount equal to the amount the Contractor would have been liable for if the actual net heat rate of the facility was equal to 105.0% of the net heat rate performance guarantee as specified in the schedule of performance liquidated damages (ii) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages. Performance guarantees not met – PLDs If for reasons not attributable to the Owner, the Contractor has met the Minimum Performance Guarantees but does not meet one or more of the Performance Guarantees by the date it has incurred or is liable for Delay Liquidated Damages up to the aggregate liability specified in the schedule of delay liquidated damages, the Contractor is liable to pay Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages. Simple regime clauses PwC 46 Performance guarantees not met after date for commercial operation – Opt out (a) Despite clauses 3.3 and 3.4, the Contractor may at any time after the Date for Commercial Operation elect to pay Performance Liquidated Damages in respect of the failure to meet either or all of the Performance Guarantees (for reasons not attributable to the Owner), provided the Minimum Performance Guarantees and the Environmental Guarantees have been met. (b) Despite clauses 3.3 and 3.4, the Owner may at any time after the Date for Commercial Operation require the Contractor to pay Performance Liquidated Damages in respect of the failure to meet any or all of the Performance Guarantees (for reasons not attributable to the Owner), provided the Minimum Performance Guarantees and the Environmental Guarantees have been met. Satisfaction of performance guarantees The payment of Performance Liquidated Damages under clause 3 will be in satisfaction of the relevant Performance Guarantee or Performance Guarantees. Environmental guarantees If the Contractor has met the Performance Guarantees or the Minimum Performance Guarantees, as the case may be, but does not, for reasons not attributable to the Owner, during the same Overall Performance Test, meet the Environmental Guarantees, the performance of the facility may, at the Contractor’s option, be derated to a level not below the Minimum Performance Guarantee levels, to enable the Emissions Guarantees to be achieved. If the Contractor elects to derate the performance of the facility, the Contractor must pay Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages for such derated performance. Availability guarantee The Contractor guarantees that the facility either in whole or in part will operate at the guaranteed availability for a period of 12 months from not later than two months after the Date of Commercial Operation. Availability – PLDs If the Availability Guarantee is not achieved, the Contractor must pay Performance Liquidated Damages as specified in the schedule of performance liquidated damages. Aggregate liability The aggregate liability of the Contractor for Performance Liquidated Damages under clause 3 will not exceed the amount calculated in accordance with the schedule of performance liquidated damages. Invoicing Performance Liquidated Damages must be invoiced by the Owner and payment must be made by the Contractor within 15 days of the date of the invoice. At the expiration of those 15 days, the amount involved is, if not paid, a debt due and payable to the Owner by the Contractor. Fair and reasonable pre-estimate The parties agree that the Performance Liquidated Damages in the schedule of performance liquidated damages are a fair and reasonable pre-estimate of the damages likely to be sustained by the Owner as a result of the Contractor’s failure to meet the Minimum Performance Guarantees and/or the Performance Guarantees. No relief (a) The payment of Performance Liquidated Damages does not in any way relieve the Contractor from any of its obligations to complete the Works or from any of its warranties, obligations or liabilities under or in connection with this contract. (b) Without prejudice to clause 3.13(a), the payment of Performance Liquidated Damages under this clause 3 is in addition to any liability of the Contractor for Delay Liquidated Damages. Simple regime clauses PwC 47 Rights at law If this clause 3 (or any part) is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Owner from claiming Performance Liquidated Damages, the Owner is entitled to claim against the Contractor for damages at law for the Contractor’s failure to meet the Performance Guarantees. Such damages must not exceed the amounts specified in the schedule of damages at law. No benefit The Contractor is not entitled to the benefit of the exclusion of liability for consequential loss under this contract in any claim for damages at law by the Owner against the Contractor pursuant to clause 3.14. Duplicate damages Nothing in this clause 3 entitles the Owner to claim duplicate damages in respect of the failure of the Contractor to meet the Performance Guarantees, the Minimum Performance Guarantees or the Availability Guarantee. Definitions Availability Guarantee means the guarantee specified as the “Availability Guarantee” in the [schedule of performance guarantees]. Availability Test means the test described as the Availability Test in the [schedule of tests]. Certificate of Commercial Operation means the certificate issued by the Owner under clause 2.2 in the form set out in the [schedule of forms of certificates]. Certificate of Final Completion means the certificate issued under clause 2.3 in the form set out in the [schedule of forms of certificates]. Certificate of Mechanical Completion means the certificate issued under clause 1.1(b) in the form set out in the [schedule of forms of certificates]. Commercial Operation means the stage of the Works when the following has occurred: (a) the Contractor has provided copies of the draft operation and maintenance manual (b) the Emissions Guarantee Test has been passed (c) the Noise Guarantee has been met (d) the Minimum Performance Guarantees have been met (e) the Performance Guarantees have been met or, where applicable, Performance Liquidated Damages have been paid (f) the facility is capable of being operated reliably, safely and efficiently under all anticipated or likely operational conditions (g) the Contractor has provided the Spare Parts required to be provided by the Date for Commercial Operation (h) the facility is in a condition which allows the Owner to comply with all laws relating to its operation (i) all documents and other information in respect of the facility required under this contract have been supplied to the Owner or the Owner’s representative (j) all government approvals to be obtained by the Contractor under the contract and which are necessary for the operation of the facility, and to the full extent permitted by law, have been transferred (to the extent necessary and/or permitted at law) to the Owner or the Owner’s nominee Simple regime clauses PwC 48 (k) the facility is complete in all respects other than minor items that in the reasonable opinion of the Owner’s representative will not prejudice (either by not being completed or as a result of the work needed to complete them), the ability of the Owner to operate the facility legally, safely, reliably and efficiently. Commissioning means the operation of the facility, or any part, by the Contractor following Precommissioning in accordance with the schedule of project technical requirements [not included], which operation is to be carried out by the Contractor as provided in clause 1.4, for the purpose of preparing the facility for operation and the carrying out of the Performance Tests. Date for Commercial Operation means, in respect of the facility, the date specified in the [schedule of guaranteed dates], as may be varied in accordance with the terms of the contract. Date of Commercial Operation means the date specified in the Certificate of Commercial Operation. Defects Liability Period means the period of 12 months from: (a) in relation to the facility as a whole, the Date of Commercial Operation (b) in relation only to where a part or parts of the facility are repaired, replaced or made good, the date of commencement in accordance with the contract as the case may be. Delay Liquidated Damages means the liquidated damages for delay specified in the relevant section of the [schedule of delay liquidated damages]. Emissions Guarantee means the guarantee specified in the [schedule of performance guarantees], which is an absolute guarantee and the meeting of which is a condition precedent to achieving Commercial Operation. Emissions Guarantee Tests means the tests specified as the emissions guarantee tests in the [schedule of tests]. Environmental Guarantees means the Emissions Guarantee and the Noise Guarantee as specified in the [schedule of performance guarantees]. Final Completion means the stage of the Works when: (a) Commercial Operation has been achieved (b) all defects and/or deficiencies have been satisfactorily remedied (c) the Defects Liability Period has expired. Mechanical Completion means that the facility has been completed mechanically and structurally in accordance with the [schedule of project technical requirements] and the other requirements of the contract such that in the reasonable opinion of the Owner’s representative the facility is substantially completed and able to operate safely, reliably and efficiently and the facility is ready for Precommissioning and Commissioning. Minimum Net Electrical Output Performance Guarantee means the minimum net output performance level specified in the schedule of performance guarantees. Minimum Net Heat Rate Performance Guarantee means the minimum net heat rate performance level specified in the schedule of performance guarantees. Minimum Performance Guarantees means the Minimum Net Heat Rate Performance Guarantee and the Minimum Net Electrical Output Performance Guarantee. Noise Guarantee means the guarantee specified as the “Noise Guarantee” in the [schedule of performance guarantees], which is an absolute guarantee and the meeting of which is a condition precedent to achieving Commercial Operation and Final Commercial Operation. Simple regime clauses PwC 49 Noise Guarantee Tests means the tests specified as the noise guarantee tests in the [schedule of tests]. Overall Performance Test means a test in which the Performance Guarantees and the Environmental Guarantees are measured simultaneously. Performance Guarantees means the performance guarantees to be met in relation to Commercial Operation as set out in the [schedule of performance guarantees] but does not include the Environmental Guarantees. Performance Liquidated Damages means the liquidated damages for underperformance of the facility as specified in the [schedule of performance liquidated damages]. Performance Tests means the tests described as Performance Tests in the [schedule of tests]. Precommissioning means the testing, checking and other works specified in the [schedule of project technical requirements] to be performed by the Contractor in preparation for Commissioning. Spare Parts means the spare parts the Contractor is obliged to provide pursuant to the contract that must, as a minimum, comprise the parts listed in the [schedule of project technical requirements]. Works means all the equipment to be supplied and the whole of the work and services to be performed by the Contractor under the contract in accordance with the contract documents and as further described in the schedule of project technical requirements and includes any variation. PwC 50 Appendix 2 Detailed regime clauses 1 Precommissioning and commissioning 1.1 Mechanical completion (a) As soon as the facility, in the opinion of the Contractor, reaches the stage of Mechanical Completion the Contractor must give a notice to the Owner’s representative (b) The Owner’s representative must, promptly, and no later than five business days after receipt of the Contractor’s notice under clause 1.1(a), either issue a Certificate of Mechanical Completion stating that the facility has reached Mechanical Completion or notify the Contractor of any defects and/or deficiencies (c) If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct those defects and/or deficiencies and the procedures described in clauses 1.1(a) and (b) must be repeated until the Owner’s representative issues a Certificate of Mechanical Completion. 1.2 Precommissioning The Contractor must comply with the Owner’s requirements and procedures in relation to Precommissioning as set out in the schedule of technical specification. 1.3 Commissioning As soon as all works in respect of Precommissioning are completed the Contractor must notify the Owner’s representative in writing that the facility is ready for the Commissioning Tests. 1.4 Requirements and procedures The Contractor must comply with the Owner’s requirements and procedures in relation to Commissioning and the performance of the Commissioning Tests as set out in the schedule of technical specification. 2 Performance tests, commercial operation and final completion 2.1 Performance tests (a) After the initial testing is completed, and the Contractor is satisfied that all requirements for Commercial Operation (other than the passing of the Performance Tests) have been met, the Contractor must notify the Owner’s representative in writing that the facility is ready for the Performance Tests (b) Each Performance Test must be completed at the time and in accordance with the procedures specified in the schedule of tests (c) The Contractor acknowledges and agrees that, despite any other provision of this contract, no partial or entire use or generation of electricity or occupancy of the site, the Works or the facility as a whole by the Owner, whether prior to, during or after the Performance Tests or otherwise, in any way constitutes an acknowledgment by the Owner that Commercial Operation has occurred, nor does it operate to release the Contractor from any of its warranties, obligations or liabilities under or in connection with this contract. Detailed regime clauses PwC 51 2.2 Commercial operation (a) After the Performance Tests are completed and the: (b) Performance Guarantees have been met (c) Minimum Performance Guarantees have been met and the Contractor elects to pay the applicable Performance Liquidated Damages in accordance with clause 3.4 (d) Minimum Performance Guarantees have been met and provided the Contractor has not incurred Delay Liquidated Damages equal to or in excess of the amount specified in section 2 of the schedule of delay liquidated damages, the Contractor elects to exercise its rights under clause 2.3 and provide security or pay the applicable Performance Liquidated Damages in accordance with clause 3.4. the Contractor must notify the Owner’s representative in writing that the facility has, in the Contractor’s opinion, reached Commercial Operation. That notice must, if applicable, also include the Contractor’s list of minor outstanding items that in its view meet the requirements of paragraph (j) of the definition of Commercial Operation and a programme for expeditiously completing those minor outstanding items. (e) The Owner’s representative must promptly, and no later than five days after receipt of the Contractor’s notice under clause 2.2(a), either issue a Certificate of Commercial Operation stating the date on which the facility has reached Commercial Operation or notify the Contractor in writing of any defects and/or deficiencies that prevent the facility from achieving Commercial Operation (f) If the Owner’s representative notifies the Contractor of any such defects and/or deficiencies, the Contractor must then remedy those defects and/or deficiencies and the procedures described in clauses 2.2(a) and (b) must be repeated until the Owner issues a Certificate of Commercial Operation (g) Upon the issue of the Certificate of Commercial Operation, the Contractor must hand over care, custody and control of the facility to the Owner (h) Notwithstanding that all the requirements for the issuing of a Certificate of Commercial Operation have not been met, the Owner may at any time, in its absolute, sole and unfettered discretion, issue a Certificate of Commercial Operation. The issue of a Certificate of Commercial Operation in accordance with this clause 2.2(e) will waive the requirement of paragraph (d) of the definition of Commercial Operation but will not operate as an admission that all the other requirements of Commercial Operation have been met, and does not prejudice any of the Owner’s rights, including the right to require the Contractor to satisfy all these requirements, nor does it release the Contractor from any of its warranties, obligations or liabilities under or in connection with this contract. 2.3 Subsequent testing period If the Contractor has elected under clause 2.2(a)(iii) to exercise its rights under this clause 2.3, the Contractor may, at any time during the Subsequent Testing Period: (a) request the facility or any part of the facility be taken out of Service (b) at its cost and expense make changes, modifications and/or additions to the facility or any part as may be necessary to meet the Performance Guarantees (c) notify the Owner upon completion of the necessary changes, modifications and/or additions (d) continue to repeat the Overall Performance Test, in order to meet the Performance Guarantees. The Owner may in its absolute discretion refuse or reschedule the Contractor’s request to take the facility or any part of the facility out of Service or otherwise modify or adapt the facility or any part of the facility as a result of operational requirements. The Contractor is solely and absolutely responsible for ensuring the facility or any part of the facility returns to Service and operates in accordance with the requirements of this contract after it is taken out of Service pursuant to this clause 2.3. In addition, the Contractor is responsible for the care, custody and control of the facility and bears the risk of loss or damage to the facility or part of the facility taken out of Service pursuant to this clause 2.3 until the facility or any such part is returned to Service. Detailed regime clauses PwC 52 During the Subsequent Testing Period, the Owner agrees that the Contractor is not liable for Delay Liquidated Damages during any scheduled outage. 2.4 Final commercial operation (a) The Contractor must notify the Owner’s representative in writing that the facility has, in the Contractor’s opinion, reached Final Commercial Operation, on: (i) the date the Contractor has incurred liability for Delay Liquidated Damages equal to the amount specified in the Schedule of Delay Liquidated Damages (ii) the expiration of the Subsequent Testing Period (iii) at any other time during the Subsequent Testing Period. (b) The Owner’s representative must promptly, and no later than five days after receipt of the Contractor’s notice under clause 2.4(a), either issue a Certificate of Final Commercial Operation stating the date on which the facility has reached Final Commercial Operation or notify the Contractor in writing of any defects and/or deficiencies that prevent the facility from achieving Final Commercial Operation. (c) If the Owner’s representative notifies the Contractor of any such defects and/or deficiencies, the Contractor must then remedy those defects and/or deficiencies and the procedures described in clauses 2.4(a) and (b) must be repeated until the Owner issues a Certificate of Final Commercial Operation. 2.5 Final completion (a) As soon as the facility, in the opinion of the Contractor, reaches the stage of Final Completion the Contractor must give a written notice to the Owner’s representative. (b) The Owner’s representative must, promptly, and no later than five days after receipt of the Contractor’s notice under clause 2.5(a), either issue a Certificate of Final Completion stating that the facility has reached Final Completion or notify the Contractor in writing of any defects and/or deficiencies that must be remedied before Final Completion can be achieved. (c) If the Owner’s representative notifies the Contractor of any outstanding defects and/or deficiencies, the Contractor must then remedy those defects and/or deficiencies and the procedures described in clauses 2.5(a) and (b) must be repeated until the Owner issues a Certificate of Final Completion. 3 Performance guarantees 3.1 Trial runs, performance guarantees, environmental guarantees (a) The Contractor guarantees that the facility as a whole and all parts will pass the trial runs and meet the: (i) Performance Guarantees (ii) Environmental Guarantees, as specified in the Schedule of Performance Guarantees and the Schedule of Tests. (b) The Contractor agrees that the meeting of the Environmental Guarantees and the passing of each trial run are absolute guarantees and requirements, the meeting and passing of which are conditions precedent to achieving Commercial Operation. Detailed regime clauses PwC 53 3.2 Minimum performance guarantees not met – Retesting If, for reasons not attributable to the Owner, either or both of the Minimum Performance Guarantees are not met during the same Overall Performance Test, the Contractor must: (a) at its cost and expense make changes, modifications and/or additions to the facility or any part as may be necessary to meet the Minimum Performance Guarantees (b) notify the Owner upon completion of the necessary changes, modifications and/or additions (c) subject to the Owner’s rights under clauses 2.2(e) and 3.3 and 3.13, continue to repeat the Overall Performance Test until the Minimum Performance Guarantees have been met during the same Overall Performance Test. Subject to clause 3.3, nothing in this clause 3.2 derogates from the Contractor’s obligation to meet the Performance Guarantees. 3.3 Minimum performance guarantees not met – PLDs Subject to clause 2.2(e), if for reasons not attributable to the Owner, the Contractor does not meet one or more of the Minimum Performance Guarantees by the date it has incurred or is liable for Delay Liquidated Damages up to the aggregate liability specified in the schedule of delay liquidated damages, the Owner may require the Contractor to pay: (a) If the Minimum Net Electrical Output Performance Guarantee has been met (but the net electrical output performance guarantee has not been met) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages (b) If the Minimum Net Electrical Output Performance Guarantee has not been met: (i) an amount equal to the amount the Contractor would have been liable for if the actual rated net output of the facility was equal to 95.0% of the net electrical output performance guarantee as specified in the schedule of performance liquidated damages (ii) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages. (c) If the Minimum Net Heat Rate Performance Guarantee has been met, (but the net heat rate performance guarantee has not been met) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages (d) If the Minimum Net Heat Rate Performance Guarantee has not been met: (i) an amount equal to the amount the Contractor would have been liable for if the actual net heat rate of the facility was equal to 105.0% of the net heat rate performance guarantee as specified in the schedule of performance liquidated damages (ii) Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages. Detailed regime clauses PwC 54 3.4 PLDs – Commercial operation If the Performance Guarantees have not been met, but the Minimum Performance Guarantees have been met, the Contractor may apply for Commercial Operation in accordance with clause 2.2 provided all the requirements for Commercial Operation have been satisfied and it: (a) pays to the Owner Performance Liquidated Damages calculated in accordance with the Schedule of Performance Liquidated Damages (b) elects under clause 2.2(a)(iii) to exercise its rights under clause 2.3 and: (i) pays to the Owner Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages that would be payable if the Contractor’s liability for Performance Liquidated Damages crystallised on the day the Contractor applied for Commercial Operation (ii) provides the Owner with an irrevocable and unconditional bank guarantee in a form and from a financial institution approved by the Owner, in its absolute discretion, for an amount equal to the Performance Liquidated Damages that would be payable if the Contractor’s liability for Performance Liquidated Damages crystallised on the day the Contractor applied for Commercial Operation. If the Contractor has met the Performance Guarantees or the Minimum Performance Guarantees, as the case may be, but does not, for reasons not attributable to the Owner, during the same Overall Performance Test, meet the Environmental Guarantee, the performance of the facility may, at the Contractor’s option, be derated to a level not below the Minimum Performance Guarantee levels, to enable the Emissions Guarantees to be met. If the Contractor elects to derate the performance of the facility, the Contractor must pay Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages for such derated performance. 3.5 PLDs – Final commercial operation (a) If the Contractor elects under clause 2.2(a)(iii) to exercise its rights under clause 2.3, on: (i) the date the Contractor has incurred liability for Delay Liquidated Damages equal to the amount specified in the schedule of delay liquidated damages (ii) the expiration of the Subsequent Testing Period (iii) the date nominated by the Contractor under clause 2.3(a)(iii), the Contractor’s liability for Performance Liquidated Damages will crystallise and the Contractor is liable for Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages. the Contractor’s liability for Performance Liquidated Damages pursuant to clause 3.5(a) is calculated by reference to the highest level at which the facility performed during the Overall Performance Test while still meeting the Environmental Guarantees. (b) If the amount calculated under clause 3.5(a) is greater than the security provided by, or the Performance Liquidated Damages paid by, the Contractor under clause 3.4(b)(i) or clause 3.4(b)(ii), as the case may be, then the Contractor must pay to the Owner the difference (c) If the amount calculated under clause 3.5(a) is less than the security provided by, or the Performance Liquidated Damages paid by, the Contractor under clause 3.4(b)(i) or clause 3.4(b)(ii) as the case may be, the Owner must either: (i) refund the Contractor from the monies paid pursuant to clause 3.4(b)(i) so that the net amount retained by the Owner is equal to amount to Performance Liquidated Damages the Contractor is liable for under clause 3.5(a) Detailed regime clauses PwC 55 (ii) release the remainder of the bank guarantee provided pursuant to clause 3.4(b)(ii) after cashing the guarantee for an amount equal to the amount of Performance Liquidated Damages the Contractor is liable for under clause 3.5(a). (d) The Contractor must, in addition to its obligation to pay Performance Liquidated Damages under clauses 3.4(b)(i) and 3.5(c) or provide security under clause 3.4(b)(ii) as the case may be, pay Performance Liquidated Damages calculated in accordance with the schedule of performance liquidated damages for the reduced performance of the facility during the period between Commercial Operation and Final Commercial Operation, less the number of days the facility is out of Service. 3.6 Availability guarantee The Contractor guarantees that the facility either in whole or in part will operate at the guaranteed availability for a period of 12 months from not later than two months after the Date of Commercial Operation. 3.7 Availability – PLDs If the Availability Guarantee is not achieved, the Contractor must pay Performance Liquidated Damages as specified in the schedule of performance liquidated damages. 3.8 Aggregate liability The aggregate liability of the Contractor for Performance Liquidated Damages under clause 3 will not exceed the amount calculated in accordance with the schedule of performance liquidated damages. 3.9 Satisfaction of performance guarantees The payment of Performance Liquidated Damages under clause 3 will be in satisfaction of the relevant Performance Guarantee. 3.10 Invoicing Performance Liquidated Damages must be invoiced by the Owner and payment must be made by the Contractor within 15 days of the date of the invoice. At the expiration of those 15 days, the amount involved is, if not paid, a debt due and payable to the Owner by the Contractor. 3.11 Fair and reasonable pre-estimate The parties agreed that the Performance Liquidated Damages in the schedule of performance liquidated damages are a fair and reasonable pre-estimate of the damages likely to be sustained by the Owner as a result of the Contractor’s failure to meet the Minimum Performance Guarantees and/or the Performance Guarantees. 3.12 No relief (a) The payment of Performance Liquidated Damages does not in any way relieve the Contractor from any of its obligations to complete the Works or from any of its warranties, obligations or liabilities under or in connection with this contract. (b) Without prejudice to clause 3.12(a), the payment of Performance Liquidated Damages under this clause 3 is in addition to any liability of the Contractor for Delay Liquidated Damages. 3.13 Rights at law If this clause 3 (or any part) is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Owner from claiming Performance Liquidated Damages, the Owner is entitled to claim against the Contractor for damages at law for the Contractor’s failure to meet the Performance Guarantees. Such damages must not exceed the amounts specified in the schedule of damages at law. 3.14 No benefit The Contractor is not entitled to the benefit of the exclusion of liability for consequential loss under this contract in any claim for damages at law by the Owner against the Contractor pursuant to clause 3.13. Detailed regime clauses PwC 56 3.15 Duplicate damages Nothing in this clause 3 entitles the Owner to claim duplicate damages at law or under this contract in respect of the failure of the Contractor to meet the Performance Guarantees, the Minimum Performance Guarantees or the Availability Guarantee. 4 Definitions Availability Guarantee means the guarantee specified as the “Availability Guarantee” in the [schedule of performance guarantees]. Availability Test means the test described as the availability test in the [schedule of tests]. Certificate of Commercial Operation means the certificate issued by the Owner under clause 2.2 in the form set out in the [schedule of forms of certificates]. Certificate of Final Commercial Operation means the certificate issued by the Owner under clause 2.4 in the form set out in the [schedule of forms of certificates]. Certificate of Final Completion means the certificate issued by the Owner under clause 2.5 in the form set out in the [schedule of forms of certificates]. Certificate of Mechanical Completion means the certificate issued under clause 1.1(b) in the form set out in the [schedule of forms of certificates]. Commercial Operation means the stage of the Works when the following has occurred: (a) the Contractor has provided copies of the draft operation and maintenance manual (b) the Emissions Guarantee Test has been passed (c) the Noise Guarantee has been met (d) one of the following has occurred: (i) the Performance Guarantees have been met (ii) the Minimum Performance Guarantees have been met and the Contractor has paid the applicable Performance Liquidated Damages (iii) the Minimum Performance Guarantees have been met and the Contractor has elected under clause 2.2(a)(iii) to exercise its rights under clause 2.3. (e) the facility is capable of being operated reliably, safely and efficiently under all anticipated or likely operational conditions (f) the Contractor has provided the Spare Parts required to be provided by the Date for Commercial Operation (g) the facility is in a condition which allows the Owner to comply with all laws relating to its operation (h) all documents and other information in respect of the facility required under this contract have been supplied to the Owner or the Owner’s representative (i) all government approvals to be obtained by the Contractor under this contract and which are necessary for the operation of the facility, and to the full extent permitted by law, have been transferred (to the extent necessary and/or permitted at law) to the Owner or the Owner’s nominee Detailed regime clauses PwC 57 (j) the facility is complete in all respects other than minor items that in the reasonable opinion of the Owner’s representative will not prejudice (either by not being completed or as a result of the work needed to complete them), the ability of the Owner to operate the facility legally, safely, reliably and efficiently. Commissioning means the operation of the facility, or any part, by the Contractor following Precommissioning in accordance with the [schedule of technical specification], which operation is to be carried out by the Contractor as provided in clause 1.3, for the purpose of preparing the facility for operation and the carrying out of the Performance Tests. Commissioning Tests means the tests specified as commissioning tests in the schedule of tests. Date for Commercial Operation means, in respect of the facility, the date specified in the [schedule of guaranteed dates], as may be varied in accordance with this contract. Date of Commercial Operation means the date specified in the Certificate of Commercial Operation. Defects Liability Period means the period of 12 months from: (a) in relation to the facility as a whole, the Date of Commercial Operation (b) in relation only to where a part or parts of the facility are repaired, replaced or made good, the date of commencement in accordance with the contract. as the case may be. Delay Liquidated Damages means the liquidated damages for delay specified in the [schedule of delay liquidated damages]. Emissions Guarantee means the guarantee specified in the [schedule of performance guarantees], which is an absolute guarantee and the meeting of which is a condition precedent to achieving Commercial Operation. Emissions Guarantee Tests means the tests specified as the emissions guarantee tests in the [schedule of tests]. Environmental Guarantees means the Emissions Guarantee and the Noise Guarantee as specified in the [schedule of performance guarantees]. Final Commercial Operation means, where paragraph (d)(iii) of the definition of Commercial Operation applies, the stage of the Works when the following has occurred: (a) Commercial Operation has been achieved (b) one of the following has occurred: (i) the Performance Guarantees have been met (ii) if applicable, the Contractor has paid Performance Liquidated Damages in accordance with clause 3.5. (c) all other preconditions to Commercial Operation have been achieved, met or passed during the Subsequent Testing Period. Final Completion means the stage of the Works when: (a) Commercial Operation has been achieved (b) if applicable, Final Commercial Operation has been achieved (c) all defects and/or deficiencies have been satisfactorily remedied Detailed regime clauses PwC 58 (d) the Defects Liability Period has expired. Mechanical Completion means that the facility has been completed mechanically and structurally in accordance with the [schedule of project technical requirements] and the other requirements of the contract such that in the reasonable opinion of the Owner’s representative the facility is substantially completed and able to operate safely, reliably and efficiently and the facility is ready for Precommissioning and Commissioning. Minimum Net Electrical Output Performance Guarantee means the minimum net output performance level specified in the [schedule of performance guarantees]. Minimum Net Heat Rate Performance Guarantee means the minimum net heat rate performance level specified in the [schedule of performance guarantees]. Minimum Performance Guarantees means the Minimum Net Heat Rate Performance Guarantee and the Minimum Net Electrical Output Performance Guarantee. Noise Guarantee means the guarantee specified as the “Noise Guarantee” in the [schedule of performance guarantees], which is an absolute guarantee and the meeting of which is a condition precedent to achieving Commercial Operation and Final Commercial Operation. Overall Performance Test means a test in which the Performance Guarantees and the Environmental Guarantees are measured together. Performance Guarantees means the performance guarantees to be met in relation to Commercial Operation and Final Commercial Operation as set out in the [schedule of performance guarantees] but does not include the Environmental Guarantees or the Availability Guarantee. Performance Liquidated Damages means the liquidated damages for underperformance of the facility as specified in the schedule of performance liquidated damages. Performance Tests means the tests specified as Performance Tests in the [schedule of tests]. Precommissioning means the testing, checking and other works specified in the schedule of technical specification to be performed by the Contractor in preparation for Commissioning. Project means the development, design, financing, construction, commissioning, testing, delivery, operation and maintenance of the facility. Service means the facility is available and is capable of meeting the Minimum Performance Guarantees, provided however that it is not in Service from the time ramp-down commences pursuant to a request from the Contractor under clause 2.4. If the facility is not generating electricity then the facility is not in Service from the time agreed between the parties following a request by the Contractor that it be taken out of Service pursuant to clause 2.3. If the parties cannot agree on the time then, provided that the Contractor has made a request pursuant to clause 2.3, the facility will be deemed to be out of Service for the time that the facility is not available. Spare Parts means the spare parts the Contractor is obliged to provide pursuant to the contract that must, as a minimum, comprise the parts listed in the [schedule of project technical requirements]. Subsequent Testing Period means the 60-day period after the Date of Commercial Operation as described in clause 2.3. Works means all the equipment to be supplied and the whole of the work and services to be performed by the Contractor under this contract and as further described in the [schedule of technical specification] and includes any variation.” PwC 59 Appendix 3 Simple regime flowchart Commercial operation, final completion and performance guarantees The Contractor may derate the Facility to a level not below the Minimum Performance Guarantee level to enable the Performance Guarantees to be achieved. If the Contractor docts to derate the Facility, the Contractor must pay FLDs if the reduced performance means that the Facility does not meet the Performance Guarantees. Commercial Operation has not been achieved Has the owner certified that the Contractor has achieved Commercial Operation after the Date for Commercial Operation? The Contractor must pay the Owner DLDs in accordance with the Contract. Final Completion has not yet been achieved. Contractor gives notice specifying intended date for commencement of Performance Tests. Mechanical Completion, Precommissioning and Commissioning of the Facility have been successfully completed. The Contractor commences the Performance Tests and any other tests required by the Owner. Has the Contractor achieved the Performance Guarantees? Has the Contractor achieved the Environmental Guarantees? Has the Owner certified that the Contractor has achieved Commercial Operation by the Date for Commercial Operation? Commercial Operation has been achieved. Have all defects/deficiencies been satisfactory remedied? Has the Defects Liability Period expired? Has the Availability Guarantee been achieved or PLDs paid in consideration for the Contractor’s failure to meet the Availability Guarantee? Has the Owner certified that the Contractor has achieved Final Completion? Final Completion has been achieved. The Contractor must repeat the Performance Tests until Minimum Performance Guarantees have been met. The Contractor is liable for DLDs as specified in teh Contract as far as the retesting period extends past the Date for Commercial Operation, and will be liable for the maximum specified PLDs if the Minimum Performance Guarantees are not met by the time DLDs cap out. Has the Contractor met the minimum Performance Guarantees! Has either the Contractor or the Owner elected, after the date of our Commercial Operation, to exercise its optout rights under Clause 3.5? Final Completion cannot be achieved until this requirement is satisfied. No No No Yes Yes Yes Yes Yes No No Yes No No No Yes Yes No Yes Yes PwC 60 Appendix 4 Simple regime timeline Simple regime completion Notes on structure The advantage of this regime is that the Owner does not assume care, custody and control of the plant (and thus does not assume responsibility or liability for it) until the Contractor has either met the Performance Guarantees or paid the appropriate Performance Liquidation Damages for its failure to meet the Performance Guarantees. This structure is more suitable where it is not viable to grant the Contractor any time after Commercial Operation in which to try and increase the Facility’s performance. Mechanical Comlpetion, Precommissioning and Commissioning carried out by the Contractor. Performance Tests to be carried out by the Contractor, after Precommissioning and Commissioning. Final Completion Defect Liability Period in relation to the Facility 12 months. Notes on Final Completion Commercial Operation Care, custody and control of Facility handed over to the Owner Notes on Commercial Operation In order to achieve Commercial Operation the Contractor must fulfill the requirements set out in the definition of Commercial Operation, unless the Owner, in its absolute, sole and unfettered discretion, issues a Certificate of Commercial Operation, notwithstanding that all requirements have not been satisfied. The Contractor may achieve Commercial Operation and be under no further obligation if the Performance Tests demonstrate that the Minimum Performance Guarantees and the Performance Guarantees have been achieved, and all other preconditions have been met. If either the Performance Guarantees have not been achieved but the Minimum Performance Guarantees have, or both the Performance Guarantees and the Minimum Performance Guarantees have not been achieved, the Contractor is obliged by Clause 3.2 to attempt to improve the performance of the Facility. Where this deferral means that Commercial Operation is not achieved by the Date for Commercial Operation, Delay Liquidated Damages will accrue; and the period in which this deferral and improvement will take place must end when the aggregate liability cap on Delay Liquidation Damages is reached. Despite the fact that Clause 3.2 requires the Contractor to continue to improve the plant after the Date for Commercial Operation, provided that the Minimum Performance Guarantees and the Environmental Guarantees have been met, at any time after the Date for Commercial Operation either the Contractor or the Owner may exercise their opt-out rights under Clause 3.5. meaning that further modifications will be halted and the Contractor’s PLDs for any continuing failure to meet the Performance Guarantees will crystallise. The Contractor is liable to pay Delay Liquidated Damages in any instance where it falls to achieve Commercial Operation by the Date for Commercial Operation. In order to achieve Final Completion, the requirements set out in the definition of Final Completion must be satisfied. If the Contractor has failed to achieve the Guaranteed Availability set out in Clause 3.8 following the Date of Commercial Operation, the Contactor must pay Performance Liquidation Damages. PwC 61 Appendix 5 Detailed regime flowchart Commercial operation, final commercial operation, final completion and performance guarantees The Contractor may derate the Facility to a level not below the Minimum Performance Guarantee (Final Commercial Operation) level to enable the Environmental Guarantees to be achieved. If the Contractor must pay PLD, if the reduced performance means that the Facility does not meet the performance Guarantees. Commercial Operation has not been achieved. Has the owner certified that the Contractor has achieved Commercial Operation after the Date for Commercial Operation? Final Commercial has not been achieved. The Contractor must pay the Owner DLDs in accordance with the Contract. Final Completion has not been achieved. Precommissioning and Commissioning of the Facility has been successfully completed Contractor gives notice specifying intended date for commencement of Performance Tests. The Contractor commences the Performance Tests and any other costs required by the Owner Has the Contractor achieved the Performance Guarantees? Has the Contractor achieved the Environmental Guarantee? Has the Owner certified that the Contractor has achieved Commercial Operation by the Date for Commercial Operation? Commercial Operation has been achieved. Did the Contractor achieve Commercial Operation by electing co use the subsequent Testing Period? The Contractor applies for Final Commercial Operation. Has the Owner certified that the Contractor has achieved Final Commercial Operation? Final Commercial Operation has been achieved. Have all defects deficiencies been satisfactory remedied? Has the Defects Liability Period expired? Has the Availability Guarantee been achieved or PLDs paid in consideration for the Contractor’s failure to meet the Availability Guarantee? Has the Owner certified that the Contractor has achieved Final Completion? Final Completion has been achieved. Has the Contractor achieved the Minimum Performance Guarantees? Has the Contractor elected to pay PLDs for not achieving the Performance Guarantees? Has the Contractor provided either PLDs or in irrevocable bank guarantee to the sum that the Contractor would be liable for if PLDs crystallises at this point? Commercial operation cannot be achieved unless the Owner in its absolute, sole and unfettered direction issues a Certificate of Commercial Operation. The Contractor must pay DLDs in accordance with the Contract for each day (and pro rata for part of a day) after the Date for Commercial Operation that the Facility is out of service. The Contractor carries out a Performance Test Before the Contractor has capped out on its DLDs, or the Subsequent Testing Period has expired, has the Contractor achieved the Performance Guarantees or has the Performance of the Facility improved since the Date of Commercial Operational The Contractor’s Liability for PLDs crystallises when the Contractor caps out on DLDs or when the Subsequent Testing Period expires. The Contractor is also liable to pay PLDs for the reduced Performance of the Facility during the period between Commercial Operations and Final Commercial Operation. Performance of the Facility must be derated to a level not below the Minimum Performance Guarantee level and Contractor must pay PLDs for the difference between the relevant guaranteed performance and the Derated performance. If applicable the Owner may utilise the bank guarantee provided by the Contractor and any balance owing is a debt due and payable by the Contractor. The Contractor must repeat the Performance Guarantee Tests until Minimum Performance Guarantees have been met. The Contractor is liable for DLDs as specified in the Contractor as far as this retesting period extends past the Date for Commercial Operation and will be liable for the minimum specified PLDs if the Minimum Performance Guarantees are not met by the time DLDs cap out. Yes Final Completion cannot be achieved until this requirement is satisfied. No No No Yes Yes Yes Yes No No Yes No No No Yes Yes Yes Yes No No Have the Environmental Guarantees been met during the same Performance Test? No Yes No Has the Contractor, within the Subsequent Testing Period, been allowed to take the Facility out of Service co enable it to modify and adapt the Facility so that it may repeat the Performance Guarantees Tests? Yes Yes No Yes No Yes No Yes No No PwC 62 Appendix 6 Detailed regime timeline Completion timeline Notes on structure The benefit of this process is that the Owner will be able to take possession of the Facility and begin generating electricity as soon as Commercial Operation is achieved (effectively, as soon as the Minimum Performance Guarantees are met). This structure is most useful where it is viable to grant (in the Owner’s discretion) the Contractor a Subsequent Testing Period in which to try and increase the Facility’s performance, secured by advantage payment (or a guarantee) equivalent to the PLDs that would otherwise be payable. Precommissioning and Commissioning by the Contractor. Performance Tests to be carried out by the Contractor, after Precommissioning and Commissioning. Performance Tests to be repeated if the Contractor elects to take advantage of its rights under Clause 2.3 and the Owner accedes to a request by the Contractor under Clause 2.3(a) for access to modify and retest the Facility. Final Completion Notes on Final Completion Commercial Operation Care, custody and control of Facility handed over to the Owner Notes on Commercial Operation In order to achieve Commercial Operation the Contractor must satisfy one of the three paragraphs in Clause 2.2(a) unless the Owner, in its absolute, sole and unfettered discretion, issues a Certificate of Commercial Operation, notwithstanding that all requirements have not been satisfied. The Contractor may achieve Commercial Operation and be under no further obligation if the Performance Guarantees have been achieved at the Performance Tests, and all other preconditions have been met. If the Performance Guarantees have not been achieved but the Minimum Performance Guarantees have, the Contractor may elect to exercise its rights under Clause 2.3 and undertake further modifications during the Subsequent Testing Period. These rights are conditional on the payment of Performance Liquidated Damages or the granting of security, and may not be exercised once the Delay Liquidated Damages cap is reached. If the Performance Guarantees have not been achieved but the Minimum Performance Guarantees have, and the Contractor does not elect to take advantage of its rights under Clause 2.3, it may pay Performance Liquidated Damages for its failure to achieve the Performance Guarantees and be released from further obligation. The Contractor is liable to pay Delay Liquidated Damages for failure to achieve Commercial Operation by the Date for Commercial Operation. The meeting of the Environmental Guarantees (Noise and Emissions) is an absolute requirement to achieving Commercial Operation. In order to achieve Final Commercial Operation, the requirements set out in the definition of Final Completion must be satisfied. If the Contractor has failed to achieve the Availability Guarantee over the 12 months following the Date of Commercial Operation, the Contractor must pay Performance Liquidated Damages. In order to achieve Final Commercial Operation the requirements set out in the definition of Final Commercial Operation must be satisfied. If the Contractor has failed to meet one or more of the Performance Guarantees, the Contractor must pay Performance Liquidated Damages in satisfaction of the relevant Performance Guarantees. The Contractor is liable to pay Delay Liquidated Damages for each day after the Date for Commercial Operation that the Facility or part of the Facility is not in Service as a result of the Contractor electing to take advantage of its rights under Clause 2.3. The meeting of the Environmental Guarantees is an absolute requirement to achieving Final Commercial Operation. Final Commercial Operation Notes on Final Commercial Operation Up to 80 days. Defects Liability Period in relation to the Facility 12 months. PwC 63 4 Position paper on contracting delivery models Purpose The purpose of this paper is to provide a brief outline of a narrow range of delivery models commonly used in the delivery of complex infrastructure projects including:  Engineering, Procure and Construct (EPC)  novated EPC  Engineering and Procurement and Construction Management (EPCM)  Project Management Contractor (PCM)  Early Contractor Involvement (ECI)  Front End Engineering Design (FEED). Choosing an appropriate delivery model is not an exact science. There is no formula into which an individual project’s peculiarities and Owner’s unique requirements can be ‘plugged in’ to produce the only correct answer. Ultimately, the choice of the delivery model is a risk management exercise in itself, involving a balancing of various factors including:  the degree of complexity of the engineering of the project and how much control the Owner wants to retain or be involved in overall design  time constraints on project delivery – for example, whether it should be executed over a normal, sequential schedule, or a fast-track schedule  the experience and capability of the Owner, including the Owner’s degree of knowledge of design and construction and the extent and nature of the Owner’s resources (including the skills and expertise of the Owner’s team)  the experience and capability of the designers and construction Contractors to be engaged to deliver the project  the size of the project (in terms of the dollar value and physical complexity)  requirements of equity and debt Financiers. Position paper on contracting delivery models PwC 64 Ancillary documents The following documents are useful to Owners when considering the appropriate delivery model and determining their appetite for risk alongside balancing the various factors described above:  a contracting and procurement plan (Appendix 1)  a risk register and action plan (Appendix 2). A contracting and procurement plan analyses and recommends a chosen project delivery model and contracting and procurement approach for committing and managing the project in order to provide a best value, best risk outcome for the project, through least capital and operational expenditure and taking into account the Lenders’ bankability requirements in respect of time and cost certainty and quality and volume of output. This plan typically provides for a “base case scenario” for formulating the detailed contracting and procurement procedures for the execution phase of a project. A risk register records details of all the risks identified for the project. Risks associated with activities and strategies are identified then graded in terms of likelihood of occurring and seriousness of impact. Risk registers typically contain the following information:  a description of each risk and its potential consequences (operational and strategic)  factors that may impact upon the likelihood and consequence of the risk  an assessed risk grade – Low, Medium, High or Extreme and whether this risk grade is acceptable  actions and controls that currently exist to mitigate risks  early warning factors and upward reporting thresholds. The process of identifying and analysing risks should be a part of tactical decision making and be dealt with in the initial planning of the project. Principal EPC Contractor Design Consultants Construction Subcontractors Suppliers EPC Contract Subcontracts Position paper on contracting delivery models PwC 65 EPC Under an EPC structure, the Principal enters into a contract with the EPC Contractor, which will then enter into various subcontracts with its sub-Contractors for performance of discrete portions of work and carry out all aspects of the design, construction and commissioning of the project. The perceived advantages of the EPC structure for an Owner include:  the degree of complexity of the engineering of the project and how much control the Owner wants to retain or be involved in over design  time constraints on project delivery – for example, whether it should be executed over a normal, sequential schedule, or a fast-track schedule  the experience and capability of the Owner, including the Owner’s degree of knowledge of design and construction and the extent and nature of the Owner’s resources (including the skills and expertise of the Owner’s team)  the experience and capability of the designers and construction Contractors to be engaged to deliver the project  the size of the project (in terms of the dollar value and physical complexity)  requirements of equity and debt Financiers  single point responsibility – the Contractor is responsible whether a fault is due to design or construction  costs – this form of delivery structure can be more economical as the design can take into account constructability issues (such as access, construction problems and particular methods of working employed by the Contractor) which can result in substantial savings  time – it can allow fast track construction due to phased construction  there is one overall contract for the Owner to manage, with design and construction warranted by a single contracting  the Owner obtains the significant extra-legal promise (not usually obtainable in either of the alternative delivery structures) of a warranty of fitness for purpose from the Contractor  guarantee or wrap – the EPC structure more easily facilitates a corporate ‘wrap’ or guarantee of the design and construction of the whole project increasing the bankability of the project  the EPC structure, or a combination of EPC structures for a project, tend to be the better ‘bankable’ form of delivery models because of the ‘perceived’ fixed time and fixed price nature of the contracts. The perceived disadvantages of the EPC delivery structure include:  the checks and balances that are usually present when design and construction are separate do not usually exist, as the design and construction are being performed through one entity  under-design – this is not frequently detectable by the Owner’s “design checking” team, and may result in latent recurrent operational or maintenance problems and costs in the completed project  the difficulty of making any genuine assessment or comparison of prices submitted by tenderers where designs differ (“comparing apples and oranges”)  it can be an expensive option if the EPC Contractor seeks to extract an excessive “price premium” for the acceptance of design risk, particularly where the Owner has controlled the earlier design process Position paper on contracting delivery models PwC 66  if the Owner finds that it must direct significant variations (usually where it has not fully or properly expressed its requirements in the functional performance brief), the EPC Contractor will usually be able to extract a significant price premium for carrying them out  an Owner must generally rely solely on one organisation for recovery of compensation if something goes wrong with the project. There may be few organisations that will be able to provide adequate financial guarantees to ensure that there is substance behind the contracting party in the event of a claim for the total failure of the project. Novated EPC There are hybrids of the EPC structure. For example, under a novated EPC approach, the Owner engages design consultants (under contracts obliging them to agree to being novated at the Owner’s direction to a construction Contractor) to carry out the design to an appropriate stage (generally speaking, a stage that is sufficiently advanced for the Owner to feel comfortable that it will receive the type and standard of facility it is seeking, but not so advanced that the benefits of an experienced construction Contractor’s buildability and other time-saving practical input will be lost), and then the Owner engages a Contractor who agrees to accept the novation of, and responsibility for the work of, the design consultants who enter into new (novated) contractual arrangements with the Contractor. The perceived advantages of the novated EPC approach for the Owner include:  the close relationship between the Owner and the design consultants at the early stages of design retains for the Owner the opportunity to monitor and provide direct input into the design process  a closer relationship between the Contractor and the design consultants in the later stages of the design process so that the design can take account of constructability issues and methods of working of the Contractor  the Owner retains the benefits of an EPC delivery model (including obtaining a warranty for fitness for purpose from and single point of responsibility in the Contractor, and a higher degree of certainty in the design process compared to the standard EPC structure). The novated EPC delivery structure’s perceived main disadvantage is that it can be the most expensive delivery structure, as there will usually be a degree of overlap and repetition, as it is incumbent on a prudent Contractor to review the designer’s design in order to be comfortable with taking over responsibility for it. EPCM Under an EPCM structure, the Owner engages an EPCM Contractor to carry out the engineering design, and to manage the procurement and construction of the project. The Owner enters into direct contracts with suppliers and construction Contractors for the project. EPCM structures may be used in the delivery of large projects where an Owner is keen to take a “hands on” approach throughout the project, often with an expectation that getting things right will take ‘fine tuning’ to design. Construction Contracts Principal EPCM Contractor Construction Contractors Suppliers Design Consultants EPC Contract Design Subcontracts Supply Contractors Position paper on contracting delivery models PwC 67 The perceived advantages of the EPCM delivery structure include:  time – it allows fast track construction due to phased design and construction. Project delivery can be competitive in overall design-construction time as compared with an EPC approach  the Owner retains better control over design development (than in an EPC approach) while at the same time, the design can take into account constructability issues (such as access, construction problems and particular methods of working employed by the Contractor) by using the construction management skills of the EPCM Contractor. The perceived disadvantages of the EPCM structure include:  there is usually no firm project cost established until construction is well underway  neither the EPCM Contractor nor the construction Contractors warrant that the project, when completed, will achieve all of the operational requirements of the project (that is, no warranty of fitness for purpose)  there is the risk that the overall quality and performance of the project may be subordinated to the EPCM Contractor’s desire to maximise cost and time performance-based incentives incorporated into its remuneration. For example, because of the inability to fix project costs, various techniques are adopted such as awarding a larger portion of the project early in the project or setting targets for each portion of the project work and then trying to maintain the targets. The techniques used to minimise cost overruns can sometimes compromise the quality of the project. In addition, the opportunity for the EPCM Contractor to cover up its own design deficiencies by the way it manages or procures construction packages is greater  the successful integration of design and construction functions and avoidance of changes/modifications to the design are largely left to the EPCM Contractor. The Owner may not be aware of potential conflicts of interest or weaknesses in the EPCM Contractor structure that may interfere with economical and timely project completion. Engineering Contracts Principal Project Management Contractor Engineering EPC Contracts Suppliers EPC Contract Management and Communication Supply Contracts EPC Contracts Position paper on contracting delivery models PwC 68 PCM Under a PCM structure, the Owner engages a Contractor to project/contract manage, or a project manager to contract/project manage to assist the Owner in the management aspects of the project delivery process. The Owner enters into direct contracts (supervised on its behalf by the PCM) with design Contractors, construction Contractors and suppliers. Under the PCM structure the manager/Contractor is nominated as the Owner’s agent to manage the direct contracts with designers, Contractors and suppliers. The perceived advantages of the PCM structure for an Owner include:  the construction management skills of the PCM can be utilised without the inherent conflict of interest of it also being the designer. The PCM can play an active role in evaluating design tendered by design Contractors, so as to effect value engineering to reduce costs and to make suggestions as to how to improve the performance outcome of the design  individual project components are performed by the most expert specialists in those fields, so that each risk is spread to those best equipped to take it and is thus minimised for the overall project  there can be independent evaluation of cost, schedule and construction performance (including evaluation for changes/modifications in design) by the PCM as it is not the designer or Contractor  full time, objective co-ordination between the design and construction Contractors (both horizontally, between different designers or between different construction Contractors, and vertically, between designers and construction Contractors) is available by dedicated resources  if the management function is well executed, project delivery can be competitive in overall designconstruction time as compared with the EPC and EPCM structures. The perceived disadvantages from an Owner’s perspective include:  in using a phased construction approach, the Owner begins the project before the total project price is established. The issue is whether the possibility of early completion is a sufficient trade-off for this cost risk  the Owner has certain responsibilities and obligations under the construction contracts that must be met in a timely manner – for example, delays in the design development or supply of Principal-supplied materials and equipment can have serious time and cost consequences for the Owner. The Owner heavily relies upon the PCM to manage the Owner’s performance of these responsibilities and obligations  similar to an EPCM delivery structure, it would be difficult to procure a warranty for fitness for purpose for the Project from either of the PCM, the design Contractors or the construction Contractors as the PCM is not performing either design or construction and neither the engineering designers or the construction Contractors are solely responsible for both the design and construction of the project  the success of project implementation to a great extent stands or falls on the planning, estimating and project management skills and resources of the PCM  the PCM does not usually give a guarantee either in terms of overall price or the quality of the work (this contrasts with the corporate ‘wrap’ or guarantee of the design and construction of the whole project given under an EPC structure). Position paper on contracting delivery models PwC 69 ECI ECI is a relational procurement method which involves Contractors in the preliminary design process and, when used correctly, is an efficient means of designing and planning infrastructure projects in a less adversarial structure. ECI is similar to a design and build contract model, the key difference being that ECI seeks to obtain the benefit of the Contractor’s specialist knowledge early in the project planning and design process, as opposed to novating a design to the Contractor which has been developed by the Owner. This procurement method comprises a two stage process:  Stage 1: the Contractor proceeds with the design development; works with the Owner on identifying, mitigating and apportioning engineering and constructability issues and risks; prepares a preliminary design; and submits a detailed design for pricing for stage 2 (which proceeds at the discretion of the Owner)  Stage 2: construction commences, usually pursuant to a design and construct model, with key construction risks and issues already identified and defined in stage 1, allowing for a guaranteed contract price for the project. Stage 2 typically includes KPI incentivisation procedures or other ways of sharing risks and rewards to continue the collaborative and cooperative themes of the ECI procurement method. Feed Similar to an ECI, a FEED contract governs the front-end engineering and design processes, typically referring to planning and design (with defined groups of activities or segments) in the early stage of a project, usually commencing after provisional project approval and will normally be completed prior to final project approvals. It is especially used for process plants. The objective of the FEED contract is to further develop and document the front-end engineering and design processes so that the Owner can obtain final project approvals; required applications to authorities can be submitted; and the resulting documents can form a basis for the design and construct contract. The perceived advantages of the ECI and FEED structures for an Owner include:  enables risks to be identified, mitigated and/or properly allocated and priced in the initial stage, allowing for a number of initial risk uncertainties to be removed so that the parties can agree to a realistic risk adjusted price  reduces the costs of tendering as only one design process is undertaken  value for money can be achieved through early Contractor involvement in design and pricing  all costs and documentation are transparent and the decision-making process allows for discussion and deeper understanding of project requirements  optimising construction efficiencies and improving profitability be reducing operating costs and ensuring more efficient delivery  the parties can work together as partners to create unique solutions for the project, building a transparent relationship where the risks of misunderstandings are reduced and a culture of blaming each other is avoided. The perceived disadvantages of both ECI and FEED structures from an Owner’s perspective include:  it does not embrace risk sharing and is therefore unsuitable for projects where risk in the construction phase remains high  it requires commitment from the top management of both the Owner and the Contractor for the entire project as transparency, an integrated team and openness of communication remain cornerstones of the ECI method. PwC 70 Appendix 1 Sample contracting and procurement plan 1 Executive summary This Plan has been prepared by the Owner and contains an overview of the recommended approach for committing and managing major works packages in order to provide a best value, least risk outcome for the Project, through least capital and operational expenditure and considering the Project’s Financiers’ requirements in respect of time and cost certainty. The recommended project delivery model is an [insert recommended contracting model and reasons for this recommendation] 2 Introduction 2.1 Purpose This Contracting and Procurement Plan (Plan) has been developed to describe the basis for the contracting and procurement plan going forward into the Implementation Phase of the Project. This Plan has also been developed for the purposes of providing guidance and support to the Capital Cost Estimate for the Definitive Feasibility Study (DFS). As such this Plan is based upon certain key principles and assumptions which are set out in Section 2 and Section 3 of this Plan. This Plan is an integral part of the Project Execution Plan (PEP) and should be read in conjunction with the PEP. This Plan provides for a “base case scenario” for formulating the contracting and procurement plan for the execution phase of the Project. This Plan will therefore be subject to modification particularly where key assumptions made during the DFS change going forward. Key assumptions this Plan relies upon include:  the perceived corporate structure adopted for operating the Project (refer to the PEP)  the perceived Project business and contracting risk profile to be adopted (refer to the PEP)  perceived market conditions during the Implementation Phase as assessed at the time of preparing this Plan  all land access, environmental, heritage and other regulatory approvals will be obtained in accordance with the Project schedule  input from the Owner’s Lenders (including Export Credit Agencies) will influence the forms of the contracts (including pricing) and the numbers of the contracts finally proposed for each work package  the Project will proceed in accordance with the current Project schedule. 2.2 The project [insert description of project] Sample contracting and procurement plan PwC 71 2.3 Overview This Contracting and Procurement Plan considers three phases of works to be implemented. These are:  Early Works: Works to be undertaken with preliminary funding through equity raising prior to the scheduled Project finance approval date  Construction Implementation Phase: Works undertaken after the Project finance approval date to construct the [facility] and all associated infrastructure  Ramp Up To Operations Phase: Specified initial operations contracts to facilitate the commencement of commercial operation by the Owner. The areas covered by this Plan are:  Early Works Packages (prior to Project finance approval date)  Site Construction and Installation Packages  Plant and Equipment Procurement (including from offshore suppliers and manufacturers)  Service Contracts  Purchase Orders  Owner’s Initial Operations Phase Packages. 2.4 Contract procurement and management procedures Contract management procedures will be based upon proven delivery and management systems from the selected Contractor, Owner and its other consultants. These procedures will be developed in conjunction with the Owner during the Project Implementation Phase and cover the following functions:  Develop and utilise a suite of shortform model contracts, with purpose written general terms and conditions and associated contract documentation  Pre-qualify suitable Contractors, suppliers and consultants for bid lists or sole source negotiation by exception  Competitively tender and award contract packages, or where appropriate in limited circumstances sole source and negotiate contract packages  Administer contracts after award including initial contract obligations, variations, claims management, warranty claims and contract close outs  Proscribe internal signing authorities and authorisations to commit capital expenditure. 3 Key principles This Plan has been developed on the basis of the following key underlying principles:  Safety, value and cost efficiency are the key drivers for the Project  Engineering and design is to be progressed to an advanced stage so that the scopes of works can be defined in sufficient detail to 1) enable Contractors to provide firm lump sum prices where possible, or, 2) if lump sum pricing is not achievable because the market dictates schedule of rates payment terms, enable the Owner to accurately assess and include overrun contingency in the Capital Cost Estimate for the DFS Sample contracting and procurement plan PwC 72  Wherever possible multidiscipline vertical packages will be awarded on a fixed time and cost basis. It is generally accepted that this will contribute to the best value, least risk outcome for the Project, the Owner and the Project’s Financiers  Whenever possible “best fit” construction companies, suppliers and manufacturers (including international companies and joint ventures) will be engaged to accord with the size and complexity of scope to be performed  Individual package values will be assessed to ensure that as a single risk exposure to the Project that the financial risk is avoided or minimised to acceptable levels  A proven and reliable set of project management and delivery systems will be utilised for Project delivery  Quality standards will be established, communicated to Contractors, and managed to attain the required quality in all areas  No “new” technology will be introduced and only proven, reliable equipment will be used  This Plan takes into account the requirements of the Project Financiers, such as time and cost certainty, the transfer of design, interface and cost overrun risk to Contractors, insurers and end users and suppliers, and Contractors nominated by any Export Credit Agencies providing funding to the Project  Detailed contracting plans will be separately completed for each of the work package summaries set out in the Contracts and Procurement Strategy Package Plan Matrix [not provided]. 4 Key assumptions 4.1 [Insert contracting model chosen] Project Delivery Model] The review process to determine the most appropriate delivery model for the Project has taken into account various factors, including:  the degree of complexity of the engineering of the Project and the degree of control and level of input the Owner wishes to retain for the overall design  fast-track schedule time constraints are not currently being imposed on project delivery  the internal experience and capability of the Owner, including the Owner’s degree of knowledge of design and construction and the extent and nature of the Owner’s resources (including the skills and expertise of the Owner’s team)  the experience and capability of the designers and construction Contractors to be engaged to deliver the Project  the availability of local and international Contractors  the size of the Project (in terms of the dollar value and physical complexity)  the requirements of equity and Lenders. The expected “boom” in the number of energy, resources and infrastructure projects to be delivered across Australia and globally, increased pressure to fast-track delivery, limitations on Owners’ resources, rising prices of commodities, materials and labour, has meant we are witnessing a re-defining of the way projects are being delivered. [Insert contracting model] contracting is just one of a number of alternative models becoming more wide spread.] The key recommendation in this Plan is that the proposed contracting structure for the Project is [Insert contracting model] structure, whereby the [Insert details of contracting model]. Sample contracting and procurement plan PwC 73 It anticipated that the Contractor will be appointed by means of a competitive tender initiated through an expression of interest process. However, there are potential benefits in single-source negotiations with the existing DFS service provider, which should be analysed before the Owner commits expenditure to a full blown tender process for the appointment of the Contractor. These include:  time and cost savings to the Owner through ongoing continuity of knowledge and resources retained by using the existing DFS services provider  liabilities for pre-FEED and FEED performed by the existing DFS services provider could be wrapped in [Insert contracting model]  time and cost savings to the Owner through existing DFS services provider needing less time to validate existing engineering and design  time and tender costs savings in the event the Owner does not get a suitable level of engagement from third party Contractors during the tender process to create a truly competitive environment because the Contractors don’t believe they can compete with the existing DFS services provider. The obvious risks in pursuing a single sourced negotiation process include:  it does not create a competitive environment and the Owner may not receive the most competitive terms and price in the market for this major package  the Owner may not be able to assess the best available resources, personnel and systems in the market  the existing DFS services provider may push for a significant risk premium in it price to take design liability for the entire Project. Recommendations will be made separately by the Owner’s project team after a cost benefit analysis of the Owner pursuing single-source negotiations with the existing DFS service provider for the [Insert contracting model] has been completed. 4.2 Project timing It is assumed that:  detail design works funding (through equity raising) will be available to allow design to commence by the Owner  early procurement activity funding (through equity raising) will be available to facilitate procurement of long lead time items by the Owner  early works funding (through equity raising) will be available and early works on site may commence by the Owner  project finance approval will be given by the Owner  an estimated [insert] % of the total value of the works packages will be locked in/awarded (subject to financial close) prior to finance approval the Owner  the EPCM Contractor will be appointed by the Owner to provide tendering and procurement services prior to finance approval  site construction other than early works will commence. Sample contracting and procurement plan PwC 74 4.3 General risk assumptions It is assumed that:  whenever possible contract packages will be constructed so as to reduce interfaces between construction Contractors, engineering disciplines and the Owner. This will reduce cost overruns and gaps in liability  the Owner will transfer construction risks to Contractors where the cost of doing so is not prohibitive  wherever possible, the engineering and scopes of work for construction packages will be sufficiently detailed to allow for firm lump sum pricing  the Owner will minimise its direct procurement of plant, equipment and bulk materials. Items of plant, equipment and bulk materials will only be purchased by the Owner for issue to construction Contractors if such procurement is required to maintain the Project schedule, reduce sequencing interface (though stockpiling of critical long lead material) or would result in a substantial cost saving to the Project. Otherwise, to avoid unnecessary interface risk, Contractors will be responsible for their own procurement, inspection, expediting, transport and storage of necessary plant, equipment and materials  common facilities, utilities and consumables will only be supplied by the Owner to Contractors where there is a clear cost and/or strategic benefit; otherwise Contractors shall be required to be “self-sufficient”  local resources will be utilised whenever possible with Indigenous participation levels actively encouraged  overseas procurement may be utilised if there are local resource constraints, such procurement is necessary to maintain the Project schedule, or it offers the opportunity to significantly reduce Project costs (eg through Export Credit Agency Funding or cheaper procurement)  during the Project Implementation Phase the resources and oil and gas construction market in Australia will be very active, resulting in the Owner having to compete for key Contractors and skilled resources (note: many of the Owner’s competitors already have strategic relationships with major Contractors and suppliers. The Owner is also competing with project Owners who are able to fund their projects off-balance sheet and therefore are not restricted by the requirements of Lender and commonly offer attractive schedule of rates or cost reimbursable terms to Contractors). 4.4 Engineering risk assumptions It is assumed that:  engineering design for the core infrastructure, including [insert details], will be sufficiently advanced (approximately [insert]% complete) at the time of tendering major construction packages to allow for firm lump sum pricing  the Owner will only detail design where necessary for non-core infrastructure construction packages (such as [insert details]), transferring detail design risks to Contractors via novated design and construct packages where the additional cost is considered acceptable and the Owner can provide sufficient detail in respect of its engineering and performance requirements  preferred equipment suppliers will be specified to Contractors where proven suppliers and equipment specifications are required for particular works packages. These suppliers may have previously negotiated pricing agreements with the Owner  sufficient geotechnical information will be available and design sufficiently advanced to enable Contractors to provide firm lump sum prices where possible, or, if lump sum pricing is not achievable because the market dictates schedule of rates payment terms, enable the Owner to accurately assess and include overrun contingency in the Capital Cost Estimate for the DFS  wherever possible the Project will utilise proven and tested designs and pre-engineered products (eg nonprocess buildings) to reduce design costs and interfaces between design, supply and install components of certain works packages Sample contracting and procurement plan PwC 75  for plant and equipment proven designs will be selected and component suppliers specified only if it provides a practical commonality of spares holdings and minimises spares inventories. 4.5 Construction risk assumptions It is assumed that:  key contracting companies will be consulted for constructability reviews during the design phase to obtain best value in design, cost and/or schedule  whenever possible process facilities contracts will be lump sum vertical multidiscipline packages, where scope will cover detailed earthworks, concrete foundations, structural, mechanical, piping, electrical and instrumentation  construction Contractors will be responsible for establishment of their temporary facilities and services where that Contractor (including subContractors) has sole use of such facilities (excluding common facilities across the Project which will be provided by the Owner)  construction camps will be provided and managed by the Owner, and construction Contractors will be charged a man day rate for the use of these facilities  railway construction contracts will be lump sum vertical multidiscipline packages including, earthworks, drainage, bridges, track laying and some signalling backbone infrastructure  earthworks for railway formation and bulk earthworks at the mine sites and port will be undertaken on a predominantly lump sum basis: – Site preparation works at the mines and the port that also involve large scale bulk earthworks will be contracted as single discipline, “horizontal” packages of work – At the mine sites the advantageous of including site preparation earthworks and drainage works in the scope of the railway Contractor or the mine pre-strip Contractor will be considered to enable economies of scale to be realised, due to the size of equipment fleets that will need to be mobilised to carry out this work – It may be advantageous to include the rail loop earthworks to a defined battery limit, in the port site preparation scope to better manage the mass balance of earthworks.  major machine items such as stackers, reclaimers, ship loaders and train unloaders will be contracted on a design, supply, erect and commission basis using proven technology and suppliers  non process buildings such as workshops, warehouses, offices and workforce accommodation will be tendered on a detailed design and erect basis with only floor plans, functional descriptions, level of fit out, nominated equipment and material and other Ownerquality and performance requirements being provided to tenderers. This will maximise the use of standardised, pre-engineered buildings and will reduce indirect (design) costs and interface/gap in liability between designers and Contractors. Railway rolling stock maintenance workshop and facilities design will be progressed by the Owner to an advanced stage before tendering due to their specialist nature and the need for the Owner to clearly articulate its functional and performance requirements. Sample contracting and procurement plan PwC 76 5 Strategy 5.1 Objective As outlined above, the objective is to obtain “best value, least risk” outcome for the Project within risk limits acceptable to the Owner and the Lenders. To achieve this objective the strategy is to:  award consolidated fixed time and cost vertical multidiscipline contract packages wherever possible  transfer risk to Contractors and insurers when value is represented  leverage upon known Contractor expertise  progress design and scopes of work to an advanced stage prior to going to tender, rather than a “fast track” procurement approach  ensure appropriately resourced internal Ownerproject team and Contractor maintained for the duration of the Project. 5.2 Market conditions The current market Ownerremains very strong with a sustained high demand for Contractor resources, construction materials and key labour skills at all levels. Whilst the impact of the global economic down turn has tempered construction activity over the past 12 month period there is now significant risk of an upturn in activity. There are several major resource and oil and gas projects now committed, or likely to be committed within the Implementation Phase of this Project. Increased market activity brings with it the risk of price escalation in both labour and materials and exacerbates the skills shortage. Since it is difficult to predict with any certainty market events and direction, the Project must be ready to adjust to a rapidly changing and ultimately competitive market environment. Contract packaging and the timing of packages to market will therefore need to retain some flexibility in order to respond to market forces. Ensuring some degree of flexibility in contract package refinement and contracting approach will assist the Project in responding positively to market forces. This Project contains long lead time commodities such as the procurement of rail rolling stock, marine piling, stacker/reclaimers and heavy mining equipment where the schedule risk must be managed. The Project must also take into account long lead and specialist construction contract performance such as the marine dredging works. Market conditions will also influence the final Project content in relation to Australian and foreign labour and/or overseas fabrication and component supply. Depending on the “tightness” of the labour market this may necessitate adjustments to the final package plan. 5.3 Project delivery systems and procedures The project delivery systems and procedures used during the Project Implementation Phase will be provided primarily by the selected Contractor (refer to Section 4 – Proposed Project Delivery Model) and further developed in conjunction with the Owner and the Owner’s other consultants. The systems, procedures and project execution documentation provided by the Contractor will be based on proven systems and specifically tailored to meet the requirements of this Project, including this Plan. As outlined above, as part of this process the Owner, in conjunction with the Contractor and the Owner’s legal advisors, will develop a suite of OwnerModel Contracts. The Owner will review and approve the project delivery systems and model contracts recommended by the Owner, the Contractor and the Owner’s legal advisors. This shall include reviewing to ensure the safety, legal, commercial, environmental, community, engineering, technical, logistical and operational needs of the Project and the Owner are met. Sample contracting and procurement plan PwC 77 5.4 Contracting approach The vertically integrated multidisciplinary packages include civil work, structural steel work, electrical, instrumentation, all services reticulation and where appropriate fit out and material procurement. Where appropriate some site preparation bulk earth works may be structured on the basis of suitably scoped horizontal packages to obtain economies of scale for such works. The contracting approach seeks to provide the Owner with the benefit of “price and time certainty” at the time of contract award. It is anticipated that Contractors will build into their contract pricing an upfront “construction risk allowance” of between 5% and 10% of the contract price to provide “price and time certainty” in terms of a firm lump sum, or design and construct price. However, off setting this up front “fixed price and time certainty premium” it is anticipated that the Project will benefit from:  a reduction in the Owner’s direct construction management and site supervision costs  a reduction in contractual claims risk due to contract awards being made on advanced design, firm pricing and reduced the Owner-Contractor interfaces  a built in profit incentive for Contractors to deliver contracts on or ahead of schedule where the Owner’s and the Contractors interests can be aligned through appropriate drafter KPI incentive regimes in the Model Form Contract  securing limited recourse project financing  being able to leverage off Contractors expertise to enhance value adding opportunities. The contracting approach provides Contractors with a high degree of freedom, allowing Contractors to control the performance of construction works with minimal Owner intervention. Each construct only and design and construct works package will require the Contractor to assume full construction and schedule risks. Contractors must be able to reasonably price these risks and the Project must be able to assess if the cost to assume these risks are reasonable and practical. The Owner must also be confident that Contractors can manage the construction risk to deliver a quality product on time before awarding contracts. Packages will therefore only be committed on a lump sum or design and construct basis if cost and overall value can be clearly demonstrated. Individual package plans will be adjusted if necessary to provide a “best value, least risk” outcome in response to either changing market conditions or commercial and construction risk factors. The contracting approach requires a substantial up front effort in the tender and contract negotiation period. Careful preparation of tender and contract documentation including scopes of work, defined battery limits between packages, technical standards and commercial terms is critical to maximising the benefits of this approach. It is therefore recommended that this preparation process be commenced and the Contractor appointed as soon as practically possible. It must be recognised that the use of large, vertically integrated lump sum contracts limits the Owner’s ability to vary design, scope, or schedule following the award of contracts without incurring the risk of significant additional cost increase. This is also the case with respect to design and construct contracts. Proposed tenderers for contract and procurement packages will be subject to a comprehensive prequalification process to verify their suitability prior to being invited to tender. Selected Contractors will therefore have demonstrated a clear understanding of project scope, schedule, and capability of delivering scopes of work safely, on time and within budget to the relevant quality requirements. Wherever possible all contract and procurement packages will be competitively tendered in the market place. This will include where deemed advantageous the requesting tenders from overseas Contractors, fabricators and suppliers. In certain instances it may be necessary to negotiate contracts from a sole source provider. Where sole sourcing is required this will be undertaken on the basis of a formal negotiation plan. The Contracting and Procurement Strategy Package Plan [not provided] will be used as the controlling document for the Project and will be revision controlled. Sample contracting and procurement plan PwC 78 5.5 Commissioning strategy Generally with the exception of bulk earthworks packages, all major contract packages will obligate Contractors to undertake precommissioning activities to effect specified “no-load testing” requirements. Manufacturers and equipment suppliers will also be required, where it is appropriate, to provide installation engineers to assist Contractors undertaking precommissioning activities. Contractors will allow for precommissioning work in their contract pricing sufficient to complete such activities and make ready for the Owner to fully commission the works. Except the extent that it relates to an EPC or other supply and install works package where the Contractor or supplier is solely responsible for commissioning, upon successful completion of precommissioning activities, Contractors and equipment suppliers will be required to assist the Owner to fully commission the mines and port process plants, mining, marine and rail plant and equipment and all other systems ready for sustained production use by the Owner’s Operators. Such commissioning assistance will include achieving full “load commissioning” and completing performance testing requirements. Contractors and suppliers will provide commissioning assistance on an “as required basis” with costs being charged on a schedule of rates basis. Contracts will therefore include a schedule of rates for provision of such commissioning assistance to the Owner. 5.6 Risk mitigation Project risks will be minimised and/or managed utilising measures which include:  award of contracts on the basis of completed design (except for EPC and D&C packages as described above) and sufficient geotechnical information  formal prequalification processes for tenderer assessment and selection  use of Model Form Contracts and tender documents for all contract and procurement activities, including tailored general conditions of contract  use of pre-prepared and approved Project technical standards  extensive use of lump sum pricing to minimise risk of capital expenditure growth  use where appropriate of contract mechanisms such as milestone payments, bonus incentives and/or liquidated damages to drive outcomes which are consistent with all the Owner’s time, cost, safety and quality/performance objectives for the Project  use of comprehensive contract administration procedures  use of both in house and third party expediting and inspection personnel to monitor conformance to specifications and schedule  use of international design personnel where appropriate  sourcing of materials, equipment and prefabricated modules from offshore when appropriate (including from Export Credit Agencies)  requiring Contractors to manage their own productivity risks  consideration of modularisation of plant and facility components so as to minimise the site based labour content. Other risks that may affect the Project for which appropriate contingency will be required include:  Government Work Place Legislation amendments and subsequent industrial relations issues in the resources industry Sample contracting and procurement plan PwC 79  increases in fuel prices and or foreign currency fluctuations which could cause cost increases in delivery of materials and services  ability to access labour in the event of either labour or skills shortages. 6 Project scope included [insert scope of project] 7 Tender process 7.1 Tender and award process In general, competitive tenders will be sought with local Contractors, suppliers and manufacturers to be given full, fair and reasonable opportunity where possible. Where sole sourcing is proposed by exception for items not listed in this Plan, a sole source justification will be required to be approved by the Owner prior to initiating negotiations, in accordance with authority levels to be established by the Project and approved by the Owner. Note on diagram: There are various “toll gates” in the contracting process that will require the prior approval of the Owner before they can proceed to the following stage. Prequalification Process Preparation of work package specific OPR Model Contract Preparation of work package specific Tender Tender Process Tender Period and Submission of Tenders Tender Evaluation Process Contract Negotiation Process Contract Award STAGE 1 STAGE 2 STAGE 10 STAGE 3 STAGE 4 STAGE 5 STAGE 6 STAGE 8 STAGE 9 Selection of Preferred Tenders Sample contracting and procurement plan PwC 80 Prior to formal tenders being called, all proposed tenderers will be formally pre-qualified by the Project. The pre-qualification process will ensure that any organisation given the opportunity to submit a formal tender for the Project will be:  capable of providing a substantive tender  financially capable to undertake the proposed scope of work  will have the resources and technical capability to perform the works. The pre-qualification process will ensure that no tenderers are included on approved tender lists that are not capable of meeting the above criteria. The tender selection process will address the following key areas:  Health and Safety  Technical Evaluation  Contractor Capabilities  Resources Capabilities Availability  Schedule Requirements  Pricing  Financial Capacity  Key Personnel  Environmental Impacts  Commitment to Indigenous employment opportunities  Local (Australian) Content. Compliance will be required with developed Project standards:  Environmental  Health and Safety  Industrial Relations  Cultural Heritage  Community Relations  Ethics and Governance. Where deemed appropriate following initial tender evaluations, tenderers may be short-listed for further detail negotiations, or re-pricing. Specific emphasis during tender evaluations will be placed on Contractor safety records, systems and previous industry experience. In particular tenderers will be required to demonstrate a thorough understanding of safety Sample contracting and procurement plan PwC 81 requirements for the Project. Short-listed tenderers will be required to submit further detail of their proposed management process for the safe implementation and management of the contract. Tenderers will also be required to demonstrate their ability to meet key milestone dates applicable in the contract schedule. A recommendation for award addressing all of the above with a capital appropriation request will be raised for approval and signing by the relevant Project personnel, in accordance with levels of authority to be established by the Project. Prior to contract award, the recommended tenderer will attend site visits to become familiarised with specific site conditions, scope of work, safety requirements and potential interface issues. Wherever possible all contracts will be awarded on the basis of a fully conformed contract document. Notices of Award or other forms of written commitment will only be used by exception where schedule demands on the Project critical path outweigh this Principal. No such commitment will be made unless it has been approved in accordance with the levels of authority to be established by the Project. Following contract award, a kick-off meeting will be held to discuss key items and information requirements, including contract close out issues. 7.2 Confidentiality Tenders will be submitted in sealed packages and be delivered to a locked tender box in a secure area by the nominated tender closing date. Tenders will be opened in accordance with a formal procedure as part of the Contract Procedures which will be developed for the Project. Unpriced copies of tenders will only be used by the lead engineers to evaluate technical aspects of the tender submissions. 7.3 Sole sourcing policy Contracts or supply packages may be sole sourced by exception where:  there is proven price competitiveness  it is necessary or significantly advantageous to the Project schedule  it provides for a commonality of spares throughout the Owner’s operations  commercial terms and conditions are advantageous  for specialist works or where Contractors with proprietary equipment or technology are required  Contractors or suppliers are suitably prequalified. Sample contracting and procurement plan PwC 82 7.4 Customs duty and Australian participation The Project contracts and procurement team shall assist in identifying and minimising any exposure to customs duties. The procurement process will ensure Australian participation is maximised in accordance with the Australian Industry Participation Plan. This will involve ensuring that full consideration is given to existing Australian capabilities to provide local personnel, suppliers, fabricators, and Contractors. Full, fair and reasonable opportunity will also be given to Australian capabilities to supply equipment, bulk materials, specialised materials and services to the Project. This commitment is to allow Australian participation to be maximised and for Australian talents, skills and economic regards to be advanced. Therefore:  preference will be given to Australian suppliers, fabricators and Contractors where technical, schedule and commercial aspects are equal to or superior to off shore providers  project design will be based on industry requirements which incorporate Australian standards and engineering practices so as to ensure maximum participation of Australian maintenance Contractors during the lifetime of the facilities  Australian content opportunities will be identified in the Contracts and Procurement Plan developed for each package. PwC 83 Appendix 2 Sample risk register and action plan Risk matrix Consequences 1 Insignificant 2 Minor 3 Moderate 4 Major 5 Catastrophic Lik elih o o d 5 Almost Certain: M H H VH VH 4 Likely: M M H H VH 3 Possible: L M H H H 2 Unlikely: L L M M H 1 Rare: L L M M H Sample risk register and action plan PwC 84 Consequences Consequence types Financial (including impacts of delays) Health and safety Natural environment Social/cultural Heritage Community/ reputation/ media Legal/govt. Variance from Business performance objectives S e v erity le v el Catastrophic >$50M Multiple fatalities, or significant irreversible effects Very serious, longterm environmental impairment of ecosystem functions Extreme social issues. Catastrophic damage to structures/items of cultural significance Significant prosecution and fines Very serious litigation including class action >30% variance from business objectives/KPI’s Major $10M – $50M Single fatality and/or severe irreversible disability (>30%) to one or more persons Significant harm with local effect On-going serious social issues. Significant damage to structures/items of cultural significance Serious public or media outcry (international coverage) Major breach of regulation. Major litigation 10% – 30% variance from business objectives/KPI’s Moderate $2M – $10M Serious injury/disabling injury Serious medium term environmental effects Significant adverse national media/public/ NGO attention Serious breach of regulation with investigation or report to authority with prosecution and/or moderate fine possible 5% – 10% variance from business objectives/KPI’s Minor $50,000M – $2M Minor injury/medical treatment Moderate, shortterm effects but not affecting ecosystem functions On-going social issues. Permanent damage to items of cultural significance Attention from media and/or heightened concern by local community. Criticism by NGOs Minor legal issues, non-compliances and breaches or regulations 2% – 5% variance from business objectives/KPI’s Insignificant <$50,000 First aid/minor health impact Minor effects on biological or physical environment Minor medium-term social impacts on local population. Mostly repairable Minor Adverse local public or media attention or complaints <2% variance from business objectives/KPI’s Sample risk register and action plan PwC 85 Likelihood Description Frequency Probability Almost certain The event will occur on an annual basis Once a year >95% Likely The event has occurred several times in your career Once every 1-5 years 60% – 95% Possible The event might occur once in your career Once every 5 – 10 years 30% – 60% Unlikely The event does occur somewhere from time to time Once every 10 – 30 years 5% – 30% Rare Heard of something like the event occurring elsewhere Once every 30 years <5% Risk levels and actions Actions required Risk le v els VH: Very high risk – CEO/Board attention needed, action plans and management responsibility specified H: High risk – senior executive management attention needed, action plans and management responsibility specified M: Medium risk – manage by specific monitoring or response procedures, with management responsibility specified L: Low risk – manage by routine procedures, unlikely to need specific application of resources Sample risk register and action plan PwC 86 Risk Register & Action Plan – Marketing & Offtake Workstream N u mber Risk description (event and consequence) Assessed category Project phase Existing controls Risk severity before treatment Ran k Risk treatment plan Risk severity after treatment Ran k Responsible person Status of risk treatment Consequence Likelihood plan Risk Level before treatment Consequence Likelihood Risk level after treatment 1 Significant changes in product quality demands (eg: less flake graphite demanded) 2 Material default and termination of cornerstone/ foundation customer offtake agreement (eg take or pay obligations cannot be enforced) 3 4 5 6 7 8 9 10 Sample risk register and action plan PwC 87 Risk Register & Action Plan – Geology, Mining, Processing and O&M Workstream N u mber Risk description (event and consequence) Assessed category Project phase Existing controls Risk severity before treatment Ran k Risk treatment plan Risk severity after treatment Ran k Responsible person Status of risk treatment plan Consequence Likelihood Risk Level before treatment Consequence Likelihood Risk Level after treatment 1 The operating and realisation expenditure cost estimates for the for each of mining, process, tailings and overhead activities have been categorised into labour, Contractors, stores, power, water, distribution, and overheads included in the DFS are excee 2 Significant increase in costs of production, eg: concrete, steel, engineering costs, salaries, equipment prices, etc. 2 Insufficient electrical and/or diesel power for mining and processing 3 Insufficient water for mining and the processing plants Sample risk register and action plan PwC 88 N u mb er Risk description Assessed category Project phase Existing controls Risk severity before treatment Ra n k Risk treatment Risk severity after treatment Ra n k Responsible person Status of risk 4 Lack of availability of competent personnel for plant operation and maintenance 5 Unsuitable ground conditions for haulage and due to lack of maintenance and increasing traffic, thus generating dust, reduces visibility. Scarcity of water may hamper water spraying. 6 Errors in the structural model, including the dip and dip direction of faults and discontinuity sets 7 Errors in geotechnical model based on the RQD data from limited geotechnical logged boreholes, with the remaining parameters subject to many assumptions. Sample risk register and action plan PwC 89 N u mb er Risk description Assessed category Project phase Existing controls Risk severity before treatment Ra n k Risk treatment Risk severity after treatment Ra n k Responsible person Status of risk 8 Hydrogeologic al model unavailable. Assumptions made of the location of the pre-mining water table and the drawdown, affecting slope stability 9 Lack of security and theft of diesel and equipment storage areas are safety and security concerns, and may lead to production delays 10 Lack of experienced mechanical fitters onsite to maintain mobile and fixed mining equipment and plant Sample risk register and action plan PwC 90 Risk Register & Action Plan – Marketing & Offtake Workstream N u mber Risk description (event and consequence) Assessed category project phase Existing controls Risk severity before treatment Ran k Risk treatment plan Risk severity after treatment Ran k Responsible person Status of risk treatment Consequence Likelihood plan Risk Level before treatment Consequence Likelihood Risk level after treatment 1 Significant changes in product quality demands (eg: less flake graphite demanded) 2 Material default and termination of cornerstone/ foundation customer offtake agreement (eg take or pay obligations cannot be enforced) 3 4 5 6 7 8 9 10 Sample risk register and action plan PwC 91 Risk Register & Action Plan – Port Access, Transport and Logistics Workstream N u mber Risk description (event and consequence) Assessed category Project phase Existing controls Risk severity before treatment Ran k Risk treatment plan Risk severity after treatment Ran k Responsible person Status of risk treatment plan Consequence Likelihood Risk level before treatment Consequence Likelihood Risk level after treatment 1 Insufficient marine and landside infrastructure, stockpiling areas and/or operating capability at the port to meet the mine short and mid term capacity requirements 2 Insufficient marine and landside infrastructure, stockpiling areas and/or operating capability at the port to meet the mine expansion capacity requirements 3 Inadequate mine to port road and drainage infrastructure to meet initial and expansions capacity during all seasons 4 Blockades at the port by workers/ dissatisfied local community Sample risk register and action plan PwC 92 N u mb er Risk description Assessed category Project phase Existing controls Risk severity before treatment Ra n kRisk treatment Risk severity after treatment Ra n kResponsible person Status of risk 5 Default by Port Operator under Port Access Agreement (eg unable to provide capacity) 6 Port Operator seeks to renegotiate terms of Port Access Agreement once substantial mine capital expenditure has been made 7 Port Operators at inbound ports refuse to unload product due to movement of product during shipping 8 9 10 Sample risk register and action plan PwC 93 Risk Register & Action Plan – Land Tenure and Approvals Workstream N u mber Risk description (event and consequence) Assessed category Project phase Existing controls Risk severity before treatment Ran k Risk treatment plan Risk severity after treatment Ran k Responsible person Status of risk treatment plan Consequence Likelihood Risk level before treatment Consequence Likelihood Risk level after treatment 1 Expropriation of assets by Government once mine infrastructure has been completed – see also Government Stability Workstream 2 Government seeks to renegotiate more favourable terms of Lease and/or Royalty Agreement once substantial mine capital expenditure has been made – see also Government Stability Workstream 3 Key project permits and approvals on the project critical path are delayed resulting in significant overall project delays and [INSERT]not being able to meet commitments to off-takers Sample risk register and action plan PwC 94 N u mb er Risk description Assessed category Project phase Existing controls Risk severity before treatment Ra n kRisk treatment Risk severity after treatment Ra n kResponsible person Status of risk 4 Breach of environmental approvals during construction or operations result in fines and critical path delays to the overall project programme and [INSERT] not being able to meet commitments to offtakers 5 6 7 8 9 10 Sample risk register and action plan PwC 95 Risk Register & Action Plan – Government Stability Workstream N u mber Risk description (event and consequence) Assessed category Project phase Existing controls Risk severity before treatment Ran k Risk treatment plan Risk severity after treatment Ran k Responsible person Status of risk treatment Consequence Likelihood plan Risk level before treatment Consequence Likelihood Risk level after treatment 1 Change in Government results in withdrawal of tenure, mining licences and/or expropriation of assets once mine infrastructure has been completed – see also Tenure and Approvals Workstream 2 3 4 5 6 7 8 9 10 Sample risk register and action plan PwC 96 Risk Register & Action Plan – Contracting, Procurement & Project Implementation Workstream Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status Consequence Likelihood Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 1 The capital expenditure cost estimates for the mine and associated permanent and temporary infrastructure included in the DFS are exceeded by >30% resulting in [INSERT] needing to raise significant additional equity and debt and which in turn significantly Financial and Schedule Post Financial Close – Implementation 1 Project Scope (and all associated infrastructure) upon which DFS cost estimates will be based is currently being defined in parallel with further geology, geotechnical and processing studies 2 DFS Study Scope currently being prepared to include clear 4 Major 3 Possible 12 High 1 Final Project Scope (and all associated infrastructure) to be locked down before DFS cost estimates are finalised 2 Cost estimate sign offs and peer reviews to be completed in line with final approved DFS Study Scope 3 Confirmation to be provided 4 Major 2 Unlikely 8 Medium 2 The Lenders' requirements in respect of time and cost certainty and transferring design and construction risk to Contractors, results in a suboptimal project delivery model under current market conditions and unacceptable risk contingency included in the Financial and Schedule Pre-Financial Close – Study 1 Financial and legal advisors have been engaged to advise on Lender requirements 2 Contracting and Procurement Plan initiated that will identify how the Lender requirements will be met 3 Market sounding/informal discussions with Contractors on what 4 Major 3 Possible 12 High 1 Complete the Contracting and Procurement Plan with input from financial advisors on Lender requirements and what is achievable in the current finance market 2 Works packages are currently to be structured (bundled) under an EPC Contract to minimise t 4 Major 2 Unlikely 6 Medium 3 EPC Contractor does not ultimately demonstrate to [INSERT] or the Lenders during the DFS that it has the capacity or resources to deliver all of the Works Packages, leading to a re-examination of the DFS estimate and delays in achieving estimate deadlines Financial and schedule Pre-Financial Close – Study 1 Market sounding and selection of major Chinese Contractor with proven track record to participate in DFS study 2 Initial due diligence carried out on balance sheet and capability 4 Major 3 Possible 12 High 1 Further due diligence on EPC Contractor's capability and balance sheet (and that of it parent companies) to be carried as early as possible in the DFS 2 Ongoing senior management engagement with shortlisted EPC Contractor 3 Market sounding to be ca 4 Major 2 Unlikely 8 Medium Sample risk register and action plan PwC 97 Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status Consequence Likelihood Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 4 EPC Contractor will not accept full lump sum/fixed time and cost risk for all of the Works Packages resulting in [INSERT] not being able to get accurate or competitive prices for the DFS and/or prices include unacceptable risk contingency, leading to a Financial and Schedule Pre-Financial Close – Study 1 Contracting and Procurement Plan initiated that will identify the limited scope of work to be let on SOR basis 2 Market sounding/informal discussions with Contractors on what is achievable in the market 3 Existing consultants and internal advice 4 Major 4 Likely 16 High 1 Complete the Contracting and Procurement Plan 2 Ongoing senior management engagement with shortlisted EPC Contractor 3 Market sounding to be carried out to identify fall back position and alterative EPC Contractors 4 Seek ongoing advice from exis 4 Major 2 Unlikely 8 Medium 5 EPC study Contractor and other Contractors not prepared to make investment in tendering, early works, etc. on an unapproved project or they refuse to accept commercial conditions associated with the tender validity period, resulting in [INSERT] not getting 1 Pre-Financial Close – Study 1 Market sounding/informal discussions with Contractors on interest in the market 2 [INSERT] has identified and interested EPC Contractor who is participating in the DFS 3 Engineering and design is being progress to an advanced stage so that the 3 Moderate 3 Possible 9 High 1 [INSERT] senior management to continue engagement with EPC study Contractor and engage with other major Contractors and suppliers to build strategic relationships as early as possible 2 Utilise PCM Contractors strategic relationships with Contractor' 4 Moderate 2 Unlikely 6 Medium 6 Inability to prepare sufficiently scoped work packages for the DFS estimate resulting in unacceptable risk contingency being included in the DFS estimate and leading to a re-examination of the estimate to ensure project viability and delays I achieving e Financial and schedule Pre-Financial Close – Study 1 Time has been allocated to progress engineering and design to an advanced stage (rather than the fast tracked design and procurement model) so that the scopes of works can be defined in sufficient detail to enable Contractors to provide firm prices when 3 Moderate 3 Possible 9 High 1 Continue to allow sufficient time (as opposed to fasttrack delivery) to progress engineering and design to an advanced stage so that the scopes of works and [INSERT] requirements for the packages can be defined in sufficient detail to enable Contractor 3 Moderate 2 Unlikely 6 Medium Sample risk register and action plan PwC 98 Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status Consequence Likelihood Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 7 Despite due diligence being carried out on the shortlisted EPC Contractor during the DFS, given the size of the Works Package the EPC Contractor does not ultimately have the capacity or resources to deliver all of the Works Packages on time, leading to de Financial and Schedule Post Financial Close – Construction Refer to actions listed in risk 3 above. 4 Major 4 Likely 16 High 1 PCM to be engaged to supervise and closely monitor performance of EPC Contractor 2 Robust security package to be included in EPC Contract with parent company guarantee and appropriate amount of performance security in the form of enforceable on-demand 4 Major 2 Unlikely 8 Medium 8 Not having fully documented EPC Contract scope of work and performance specification at the time of awarding the EPC Contract, leading to uncertainty and [INSERT] paying unacceptable Contractor claims. Financial and schedule Post Financial Close – Construction 1 Time has been allocated to progress engineering and design to an advanced stage (rather than the fast tracked design and procurement model) so that the scopes of works can be defined in sufficient detail to enable Contractors to provide firm prices when 3 Moderate 3 Possible 9 High 1 Allow sufficient time and don't go to the market until the tender packages are advanced and the scopes of works and contractual terms for the packages have been defined in sufficient detail to enable Contractors to provide firm prices where possible 2 3 Moderate 2 Unlikely 6 Medium 9 [INSERT] may not be able to transfer all of the existing design prepared in the DFS and responsibility for timely delivery of all design going forward to the EPC Contract, leading to gaps in design liability and delays in delivering the design. Financial and schedule Post Financial Close – Construction 1 Gap analysis of design risk has been initiated; 2 Using proven technology where possible; 3 Shortlisted EPC Contractor has been engaged to prepare concept design for the DFS 3 Moderate 3 Possible 9 High 1 PCM model whereby the PCM Contractor/other engineering specialists will peer review critical design prepared by EPC Contractor 2 Starting point in EPC Contract is that EPC Contractor accepts responsibility for all design on a full turnkey basis; 3 E 3 Moderate 2 Unlikely 6 Medium Sample risk register and action plan PwC 99 Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status Consequence Likelihood Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 10 The interests of [INSERT] and the PCM Contractor are not sufficiently aligned to drive Project outcomes that are consistent with [INSERT] objectives in respect of cost, time, quality, safety etc. Financial and Schedule Post-Financial Close – Construction 1 Incentivised PCM contract model is being proposed; 2 [INSERT] existing consultant and internal advice is being sought on what I achievable on KPI incentive regimes on past projects and in the current market. 4 Major 3 Possible 12 High 1 Allow sufficient time so that [INSERT] requirements and objectives for the PCM contract can be defined in sufficient detail to enable [INSERT] and the PCM Contractor to agree a target man hour schedule and estimated target cost so the PCM Contractor ca 3 Moderate 2 Unlikely 6 Medium 11 Inefficiencies and difficulties arising from [INSERT] appointing multiple PCM Contractors, including having different management systems, agreeing on standard form contracts, quality of services, approach to KPIs etc. Financial and schedule Post-Financial Close – Construction 1 Single PCM contract model is being proposed. 2 Minor 4 Likely 8 Medium 1 Single PCM Contractor to be appointed 2 [INSERT] to engage internal resource to match PCM structure and systems 2 Minor 2 Unlikely 4 Low 12 DFS estimate will include duplication of overheads and contingencies causing re-examination of estimate and delays in achieving a robust DFS estimate by the deadlines. Schedule Pre-Financial Close – Study 1 [INSERT] have engaged Internal and external technical, legal, commercial and insurance resources; 2 External peer reviews are being conducted; 3 Engineering and design is being progress to an advanced stage so that the scopes of works and [INSERT] r 2 Minor 3 Possible 6 Medium 1 Further value engineering analysis to be completed 2 Estimate figures are not to be released until the value engineering process is complete 3 Allow sufficient time to complete value engineering process 4 External peer review to be completed 5 2 Minor 2 Unlikely 4 Low 13 Industrial Relations implications and renegotiation of labour agreements has adverse impact on contracting and procurement. Financial and schedule Post-Financial Close – Construction 1 [INSERT] considering engaging external IR consultant with specific regional expertise. 2 Minor 3 Possible 6 Medium 1 IR Strategy document to be prepared 2 Establish project wide minimum IR requirements 3 Include status of Contractor’s IR agreements and consider renegotiation cycles in the tender evaluation process; 4 IR risk to be assumed by Contractors under co 2 Minor 2 Unlikely 4 Low Sample risk register and action plan PwC 100 Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status Consequence Likelihood Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 14 Difficulty procuring suitably priced project wide insurance to meet Lenders requirements. Financial Post Financial Close – Construction 1 [INSERT] have engaged insurance broker to advise on insurance available in the market 2 Minor 2 Unlikely 4 Low 1 Insurance strategy to be prepared including an assessment of the benefits and risks of [INSERT] vs. Contractor procured insurance strategy; 2 Gap analysis on Contractor insurances to establish residual project insurance cover required. 2 Minor 1 Rare 3 Low 15 Contractors are not prepared to tender because of the nature of the [INSERT] SPV set up for the project entering into the Works Packages, resulting in [INSERT] not getting a suitable level of engagement to create a truly competitive environment and leading Financial and schedule Pre-Financial Close – Study 1 Market sounding and selection of major Chinese Contractor with proven track record to participate in DFS study 2 Initial due diligence carried out on balance sheet and capability 4 Major 3 Possible 12 High 1 Ongoing senior management engagement with shortlisted EPC Contractor; 2 Explanation given to EPC Contractor regarding financing arrangements to provide further comfort it will get paid; 3 Consider advance payments for mobilisation and long lead procu 4 Major 2 Unlikely 12 Medium 16 Single PCM Contractor is not able to provide adequate resources or suitably experienced personnel. Financial and schedule Post Financial Close – Construction 1 [INSERT] existing consultant and internal advice is being sought on what is available in the current market 4 Major 3 Possible 12 High 1 Market testing and sounding through EOI process; 2 Resources and key personnel will be key criteria in the EOI and tender evaluation processes; 3 LDs and/or KPI incentive payments for resourcing and key personnel to be incorporated into the PCM cont 4 Major 2 Unlikely 8 Medium Sample risk register and action plan PwC 101 Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status Consequence Likelihood Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 17 Delay and disruption caused by loss of continuity in progress, knowledge and resource if [INSERT] does not appoint the current lead and other study Contractors during the implementation phase. Financial and Schedule Post Financial Close – Construction 1 Market sounding and selection of team of DFS Contractors with proven track record to participate in DFS study; 2 Initial due diligence carried out on balance sheet and capability; 4 Major 3 Possible 12 High 1 Further due diligence on EPC Contractor's capability and balance sheet (and that of it parent companies) to be carried as early as possible in the DFS 2 Ongoing senior management engagement with shortlisted EPC Contractor; 3 Market sounding to be ca 4 Major 2 Unlikely 6 Medium 18 [INSERT] is not able to source adequate resources or suitably experienced personnel. Financial and schedule Post Financial Close – Construction 4 Major 3 Possible 12 High 1 [INSERT] internal resourcing/ employment strategy to be prepared 2 Ongoing market testing of availability of key personnel; 3 Engage HR resource to prepare strategy and locate key personnel. 3 Major 2 Unlikely 6 Medium 19 EPC Contractor unable to fund start up working capital on such a large scope of work, resulting in [INSERT] having to fund significant advance payments. Financial Post Financial Close – Construction 1 Financial and legal advisors have been engaged to advise on Lender requirements; 2 Market sounding/inform al discussions with Contractors on what is expected in the market; 3 [INSERT] existing consultants and internal advice is being sought on what 3 Moderate 3 Possible 9 High 1 Complete the Contracting and Procurement Plan with input from financial advisors on Lender requirements and what is achievable in the current finance market (eg debt funding for the advance payment) 2 Ongoing engagement with shortlisted EPC Contract 3 Moderate 2 Unlikely 8 Medium Sample risk register and action plan PwC 102 Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status Consequence Likelihood Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 20 Contractors do not finish on time causing [INSERT] to incur additional accommodation and overheads associated with [INSERT] workers accommodation camps. Financial Post Financial Close – Construction 1 [INSERT] existing consultants and internal team are analysis potential risk and cost implications. 4 Major 4 Likely 16 High 1 Prepare Accommodation Plan 2 Pass on costs to Contractors in construction contracts through LDs and indemnities; 3 Allow contingency in DFS estimate to fund additional costs until recovered from Contractors. 2 Minor 3 Possible 6 Medium Sample risk register and action plan PwC 103 Risk Register & Action Plan – Financing Workstream Number Risk Description (Event and Consequence) Assessed Category Project Phase Existing Controls Risk Severity Before Treatment Rank Risk Treatment Plan Risk Severity After Treatment Rank Responsible Person Status of Risk Treatment Consequence Likelihood Plan Risk Level Before Treatment Consequence Likelihood Risk Level After Treatment 1 2 3 4 5 6 7 8 9 10 PwC 104 EPC and EPCM Contracts PwC 105 5 EPC Contracts in the oil and gas sector Introduction Engineering, procurement and construction (EPC) contracts are a common form of contract used to undertake construction works by the private sector on large-scale and complex oil and gas projects.1 Under an EPC Contract a Contractor is obliged to deliver a complete facility to a Developer who need only turn a key to start operating the facility, hence EPC Contracts are sometimes called turnkey construction contracts. In addition to delivering a complete facility, the Contractor must deliver that facility for a guaranteed price by a guaranteed date and it must perform to the specified level. Failure to comply with any requirements will usually result in the Contractor incurring monetary liabilities. It is timely to examine EPC Contracts and their use in oil and gas projects given the bad publicity they have received, particularly in contracting circles. A number of Contractors have suffered heavy losses and, as a result, a number of Contractors now refuse to enter into EPC Contracts in certain jurisdictions. This problem has been exacerbated by a substantial tightening in the insurance market. Further, some project proponents believe that the project delivery methods such as engineering, procurement, and construction management (EPCM) contracts give them greater flexibility and that they have the expertise and experience required to control costs in an EPCM Contract. However, because of their flexibility, the value and the certainty Sponsors and Lenders derive from EPC Contracts, the authors believe EPC Contracts will continue to be a pre-eminent form of construction contract used on large-scale oil and gas projects in most jurisdictions.2 This paper will only focus on the use of EPC Contracts in the oil and gas sector. However, the majority of the issues raised are applicable to EPC Contracts used in all sectors. Prior to examining power project EPC Contracts in detail, it will be useful to explore the basic features of an oil and gas project. 1 By this we mean oil, gas and derivatives of the same such as methanol, fertiliser etc. See also David Roe, LNG Trade: A Review of Markets, Projects and Issues in the Changing World of LNG, (SMI Publishing Ltd, 2003), 119. 2 Some jurisdictions, such as the USA, use alternative structures which separate the work into various components. Sample risk register and action plan PwC 106 Basic features of an oil and gas project The contractual structure The diagram below illustrates the basic contractual structure of a simple project-financed oil and gas project using an EPC Contract.3 The detailed contractual structure will vary from project to project. However, most projects will have the basic structure illustrated above.4 As can be seen from the diagram, the operating company will usually enter into agreements which cover the following elements:  An operating agreement with the joint venture (JV) participants which gives the operating company the right to construct and operate the oil and gas facility. Usually, each JV participant will sell its own share of the product. This is even the case if participants jointly market the product. Traditionally the operating agreement is a joint operating agreement (JOA) between the JV participants whereby one of the participants operates the facility. There is a significant advantage in this structure as it means that one body is responsible for the delivery of projects, relationships with government, customers and Contractors. The JOA governs how liability is spread amongst participants with respect to any liabilities or obligations incurred by the Operator. Generally, the participants have several liabilities and the Operator makes cash calls on them in proportion to their respective JV shares to fund capital expenditure. A special purpose vehicle can also be created to fulfil this role but usually the control of this vehicle will be in the hands of one of the JV participants.  Many oil and gas companies have the ability to use corporate finance from the balance sheet, however this is not always the case. There are a number of smaller oil and gas companies looking to develop assets that are regarded as stranded or too small for the larger companies to operate profitably. These companies require finance to carry out these developments. In these cases, the EPC Contractor must be a large, experienced participant in the industry which the Sponsors and Lenders are confident can successfully deliver the project, and is large enough to cope with losses if it does not. Further, companies with a successful track record mean that insurance for the project is easier to obtain. The larger Owners will still use an EPC Contract or design and construct contract for parts of large projects even if self-management, EPCM or other project management contracts are used for the balance of the project. 3 An LNG project would also usually involve a shipping deal and/or pipeline aspects. 4 Even if the project is developed by a large conglomerate there are usually contracts between the various entities. For example, where the proponent will also be the supplier there will often be a supply agreement put in place so that the new project is properly defeasible and business property accountable Joint venture Project Company/Oil and Gas Field Operator Off taker Possibly one or more of the JV participants Lenders EPC Contractor O&M Contractor Oil and Gas Supplier EPC Contract Equity Support Agreements O&M Contract Operating Agreement Financing and Security Agreements Offtake Agreement Tripartite Agreements EPC Contracts in the oil and gas sector PwC 107  There are a number of contractual approaches that can be taken to construct an oil and gas facility. An EPC Contract is one approach. Another option is to have a supply contract, a design agreement and construction contract with or without a project management agreement. The project management can be, and often is, carried out by the proponent itself. Alternatively, an EPCM or other project management contract can be used for managing the project. The choice of contracting approach will depend on a number of factors including the time available, the Lender’s requirements, the sophistication of the proponent, and the identity of the Contractor(s). The major advantage of the EPC Contract over the other possible approaches is that it provides for a single point of responsibility. This is discussed in more detail below. Interestingly, on large project-financed derivative projects the Contractor is increasingly becoming one of the Sponsors (ie an equity participant) in the Project Company. This is not the case in traditional oil and gas projects. Contractors will ordinarily sell down their interest after financial close because, generally speaking, Contractors will not wish to tie up their capital in operating projects. In addition, once construction is complete the rationale for having the Contractor included in the Ownership consortium often no longer exists. Similarly, once construction is complete a project will normally be reviewed as lower risk than a project in construction, therefore, all other things being equal, the Contractor should achieve a good return on its investments.  Large overarching operating and maintenance agreements (O&M Agreements) are uncommon in the oil and gas industry. Industry participants are generally in the business of managing these facilities. However, components of the operations are usually contracted out.  Offtake agreements govern the sale of the product of the project. For gas projects and hydrocarbon derivative projects these agreements are crucial to the development proceeding. Financiers will not lend the funds and boards will not approve the project if there are no customers locked in to take the product. The impact of the offtake agreement is on practical completion. If there are take or pay agreements it is vital that the project is ready to deliver product from inception date of the offtake agreement or it will face penalties. It may even have to buy product on the open market to meet its obligations. As these markets are usually thinly traded these can be a costly exercise. Oil projects can be underpinned by long-term contracts but it is not the norm.  Financing and security agreements with the Lenders to finance the development of the project. Accordingly, the construction contract is only one of a suite of documents on an oil and gas project. Importantly, the promoter or the JV participants of the project operate and earn revenues under contracts other than the construction contract. Therefore, the construction contract must, where practical, be tailored so as to be consistent with the requirements of the other project documents. As a result, it is vital to properly manage the interfaces between the various types of agreements. These interface issues are discussed in more detail later in this paper. Bankability A bankable contract is a contract with a risk allocation between the Contractor and the Project Company that satisfies the Lenders. Lenders focus on the ability (or more particularly the lack thereof) of the Contractor to claim additional costs and/or extensions of time as well as the security provided by the Contractor for its performance. The less comfortable the Lenders are with these provisions the greater amount of equity support the Sponsors will have to provide. In addition, Lenders will have to be satisfied as to the technical risk. Obviously price is also a consideration but that is usually considered separately to the bankability of the contract because the contract price (or more accurately the capital cost of the project facility) goes more directly to the economic bankability of the project as a whole. Before examining the requirements for bankability it is worth briefly considering the appropriate financing structures and lending institutions. Historically, the most common form of financing for oil and gas projects is project financing. Project financing is a generic term that refers to financing secured only by the assets of the project itself. Therefore, the revenue generated by the project must be sufficient to support the financing. Project financing is also often referred to as either “non-recourse” financing or “limited recourse” financing. The terms “non-recourse” and “limited recourse” are often used interchangeably, however, they mean different things. “Non-recourse” means there is no recourse to the project Sponsors at all and “limited recourse” means, as the name suggests, there is limited recourse to the Sponsors. The recourse is limited both in terms of when it Sample risk register and action plan PwC 108 can occur and how much the Sponsors are forced to contribute. In practice, true non-recourse financing is rare. In most projects the Sponsors will be obliged to contribute additional equity in certain defined situations. Traditionally, project financing was provided by commercial Lenders. However, as projects became more complex and financial markets more sophisticated project finance also developed. In addition, as well as bank borrowings, Sponsors are also using more sophisticated products like credit-wrapped bonds, securitisation of future cash flows and political, technical and completion risk insurance to provide a portion of the necessary finance. In assessing bankability, Lenders will look at a range of factors and assess a contract as a whole. Therefore, in isolation it is difficult to state whether one approach is or is not bankable. However, generally speaking, the Lenders will require the following:  a fixed completion date  a fixed completion price  no or limited technology risk  output guarantees  liquidated damages for both delay and performance  security from the Contractor and/or its parent  large caps on liability (ideally, there would be no caps on liability, however, given the nature of EPC Contracting and the risks to the Contractors involved there are almost always caps on liability)  restrictions on the ability of the Contractor to claim extensions of time and additional costs. An EPC Contract delivers all of the requirements listed above in one integrated package. This is one of the major reasons why they are the predominant form of construction contract used on large-scale project financed infrastructure projects and why they can be effective on a variety of oil and gas projects. Basic features of an EPC Contract The key clauses in any construction contract are those which impact on:  time  cost  quality. The same is true of EPC Contracts. However, EPC Contracts tend to deal with issues with greater sophistication than other types of construction contracts. This is because, as mentioned above, an EPC Contract is designed to satisfy the Lenders’ requirements for bankability. EPC Contracts provide for:  A single point of responsibility: The Contractor is responsible for all design, engineering, procurement, construction, commissioning and testing activities. Therefore, if any problems occur the Project Company need only look to one party – the Contractor – to fix the problem and provide compensation. As a result, if the Contractor is a consortium comprising several entities the EPC Contract must state that those entities are jointly and severally liable to the Project Company.  A fixed contract price: Risk of cost overruns and the benefit of any cost savings are to the Contractor’s account. The Contractor usually has a limited ability to claim additional money which is limited to EPC Contracts in the oil and gas sector PwC 109 circumstances where the Project Company has delayed the Contractor or has ordered variations to the works.  A fixed completion date: EPC Contracts include a guaranteed completion date that is either a fixed date or a fixed period after the commencement of the EPC Contract. If this date is not met the Contractor is liable for delay liquidated damages (DLDs). DLDs are designed to compensate the Project Company for loss and damage suffered as a result of late completion of the facility. To be enforceable in common law jurisdictions, DLDs must be a genuine pre-estimate of the loss or damage that the Project Company will suffer if the facility is not completed by the target completion date. The genuine pre-estimate is determined by reference to the time the contract was entered into. DLDs are usually expressed as a rate per day which represents the estimated extra costs incurred (such as extra insurance, supervision fees and financing charges) and losses suffered (revenue forgone) for each day of delay. In addition, the EPC Contract must provide for the Contractor to be granted an extension of time when it is delayed by the acts or omissions of the Project Company.  Performance guarantees: The Project Company’s revenue will be earned by operating the facility. Therefore, it is vital that the facility performs as required in terms of output, efficiency and reliability. Therefore, EPC Contracts contain performance guarantees backed by performance liquidated damages (PLDs) payable by the Contractor if it fails to meet the performance guarantees. PLDs must also be a genuine pre-estimate of the loss and damage that the Project Company will suffer over the life of the project if the facility does not achieve the specified performance guarantees. As with DLDs, the genuine pre-estimate is determined by reference to the time the contract was signed. It is possible to have a separate contract that sets out the performance requirements, testing regime and remedies. However, this can create problems where the EPC and the performance guarantees do not match. In our view, the preferred option is to have the performance guarantees in the EPC Contract itself. PLDs and the performance guarantee regime and its interface with the DLDs and the delay regime is discussed in more detail in the section on key performance clauses.  Caps on liability: As mentioned above most EPC Contractors will not, as a matter of company policy, enter into contracts with unlimited liability. Therefore, EPC Contracts for oil and gas projects cap the Contractor’s liability at a percentage of the contract price. This varies from project to project, however, a cap of 100 percent of the contract price is common. In addition, there are normally subcaps on the Contractor’s liquidated damages liability. For example, DLDs and PLDs might each be capped at 20 percent of the contract price with an overall cap on both types of liquidated damages of 30 percent of the contract price. There will also likely be a prohibition on the claiming of consequential losses. Put simply, consequential losses are those losses which do not flow directly from a breach of contract but which were in the reasonable contemplation of the parties at the time the contract was entered into. This used to mean heads of damage like loss of profit. However, loss of profit is now usually recognised as a direct loss on project-financed projects and, therefore, would be recoverable under a contract containing a standard exclusion of consequential loss clause. Nonetheless, care should be taken to state explicitly that liquidated damages can include elements of consequential loss. Given the rate of liquidated damages is pre-agreed most Contractors will not object to this exception. In relation to both caps on liability and exclusion of liability it is common for there to be some exceptions. The exceptions may apply to either or both the cap on liability and the prohibition on claiming consequential losses. The exceptions themselves are often project specific, however, some common examples include cases of fraud or wilful misconduct, in situations where the minimum performance guarantees have not been met and the cap on delay liquidated damages has been reached and breaches of the intellectual property warranties.  Security: It is standard for the Contractor to provide performance security to protect the Project Company if the Contractor does not comply with its obligations under the EPC Contract. The security takes a number of forms including: Sample risk register and action plan PwC 110 – A bank guarantee or bond for a percentage, normally in the range of 5–15 percent, of the contract price. The actual percentage will depend on a number of factors including the other security available to the Project Company, the payment schedule (because the greater the percentage of the contract price unpaid by the Project Company at the time it is most likely to draw on security ie to satisfy DLD and PLD obligations the smaller the bank guarantee can be), the identity of the Contractor and the risk of it not properly performing its obligations, the price of the bank guarantee and the extent of the technology risk. – Retention ie withholding a percentage (usually 5–10 percent) of each payment. Provision is often made to replace retention monies with a bank guarantee (sometimes referred to as a retention guarantee (bond). – Advance payment guarantee, if an advance payment is made. – A parent company guarantee – this is a guarantee from the ultimate parent (or other suitable related entity) of the Contractor which provides that it will perform the Contractor’s obligations if, for whatever reason, the Contractor does not perform.  Variations: The Project Company has the right to order variations and agree to variations suggested by the Contractor. If the Project Company wants the right to omit works either in their entirety or to be able to engage a different Contractor this must be stated specifically. In addition, a properly drafted variations clause should make provision for how the price of a variation is to be determined. In the event the parties do not reach agreement on the price of a variation the Project Company or its representative should be able to determine the price. This determination is subject to the dispute resolution provisions. In addition, the variations clause should detail how the impact, if any, on the performance guarantees is to be treated. For some larger variations the Project Company may also wish to receive additional security. If so, this must also be dealt with in the variations clause.  Defects liability: The Contractor is usually obliged to repair defects that occur in the 12 to 24 months following completion of the performance testing. Defects liability clauses can be tiered ie the clause can provide for one period for the entire facility and a second, extended period, for more critical items.  Intellectual property: The Contractor warrants that it has rights to all the intellectual property used in the execution of the works and indemnifies the Project Company if any third parties’ intellectual property rights are infringed.  Force majeure: The parties are excused from performing their obligations if a force majeure event occurs.  Suspension: The Project Company usually has the right to suspend the works.  Termination: This sets out the contractual termination rights of both parties. The Contractor usually has very limited contractual termination rights. These rights are limited to the right to terminate for nonpayment or for prolonged suspension or prolonged force majeure and will be further limited by the tripartite or direct agreement between the Project Company, the Lenders and the Contractor. The Project Company will have more extensive contractual termination rights. They will usually include the ability to terminate immediately for certain major breaches or where the Contractor becomes insolvent, and the right to terminate after a cure period for other breaches. In addition, the Project Company may have a right to terminate for convenience. It is likely the Project Company’s ability to exercise its termination rights will also be limited by the terms of the financing agreements.  Performance specification: Unlike a traditional construction contract, an EPC Contract usually contains a performance specification. The performance specification details the performance criteria that the Contractor must meet, but does not dictate how they must be met. This is left to the Contractor to determine. A delicate balance must be maintained. The specification must be detailed enough to ensure the Project Company knows what it is contracting to receive but not so detailed that if problems arise the Contractor can argue they are not its responsibility. Whilst there are, as described above, numerous advantages to using an EPC Contract, there are some disadvantages. These include the fact that it can result in a higher contract price than alternative contractual structures. This higher price is a result of a number of factors not least of which is the allocation of almost all the construction risk to the Contractor. This has a number of consequences, one of which is that the Contractor EPC Contracts in the oil and gas sector PwC 111 will have to factor in to its price the cost of absorbing those risks. This will result in the Contractor building contingencies into the contract price for events that are unforeseeable and/or unlikely to occur. If those contingencies were not included the contract price would be lower. However, the Project Company would bear more of the risk of those unlikely or unforeseeable events. Sponsors have to determine, in the context of their particular project, whether the increased price is worth paying. As a result, Sponsors and their advisers must critically examine the risk allocation on every project. Risk allocation should not be an automatic process. Instead, the Project Company should allocate risk in a sophisticated way that delivers the most efficient result. For example, if a project is being undertaken in an area with unknown geology and without the time to undertake a proper geotechnical survey, the Project Company may be best served by bearing the site condition risk itself as it will mean the Contractor does not have to price a contingency it has no way of quantifying. This approach can lower the risk premium paid by the Project Company. Alternatively, the opposite may be true. The Project Company may wish to pay for the contingency in return for passing on the risk which quantifies and caps its exposure. This type of analysis must be undertaken on all major risks prior to going out to tender. Another consequence of the risk allocation is the fact that there are relatively few engineering and construction companies that can and are willing to enter into EPC Contracts. As mentioned in the Introduction some bad publicity and a tightening insurance market have further reduced the pool of potential EPC Contractors. The scarcity of EPC Contractors can also result in relatively high contract prices. Another major disadvantage of an EPC Contract becomes evident when problems occur during construction. In return for receiving a guaranteed price and a guaranteed completion date, the Project Company cedes most of the day-to-day control over the construction. Therefore, Project Companies have limited ability to intervene when problems occur during construction. The more a Project Company interferes during the construction, the greater the likelihood of the Contractor claiming additional time and costs. In addition, interference by the Project Company will make it substantially easier for Contractors to defeat claims for liquidated damages and defective works. Obviously, ensuring the project is completed satisfactorily is usually more important than protecting the integrity of the contractual structure. However, if a Project Company interferes with the execution of the works they will, in most circumstances, have the worst of both worlds. They will have a contract that exposes them to liability for time and costs incurred as a result of their interference without any corresponding ability to hold the Contractor liable for delays in completion or defective performance. The same problems occur even where the EPC Contract is drafted to give the Project Company the ability to intervene. In many circumstances, regardless of the actual drafting, if the Project Company becomes involved in determining how the Contractor executes the works then the Contractor will be able to argue that it is not liable for either delayed or defective performance. As a result, it is vitally important that great care is taken in selecting the Contractor and in ensuring the Contractor has sufficient knowledge and expertise to execute the works. Given the significant monetary value of EPC Contracts, and the potential adverse consequences if problems occur during construction, the lowest price should not be the only factor used when selecting Contractors. Sample risk register and action plan PwC 112 Split EPC Contract Particularly in the Middle East and South Asia region (eg Egypt, India), one common variation to the basic EPC Contract structure illustrated above is a split EPC Contract. Under a split EPC Contract, the EPC Contract is, as the name implies, split into two or more separate contracts. The basic split structure involves splitting the EPC Contract into an onshore construction contract and an offshore supply contract: Example simple split EPC Contract structure There are two main reasons for using a split contract. The first is because it can result in a lower contract price as it allows the Contractor to make savings in relation to onshore taxes, in particular on indirect and corporate taxes in the onshore jurisdiction. The second is because it may reduce the cost of complying with local licensing regulations by having more of the works, particularly the design works, undertaken offshore.5 In addition, in some countries which impose restrictions on who can carry out certain activities like engineering and design services, splitting the EPC Contract can also be advantageous because it can make it easier to repatriate profits. Below is a diagram illustrating a more complex split EPC structure we have used previously that dealt with both tax and licensing issues. Example complex split EPC Contract structure Whilst a split EPC Contract can result in cost savings, there are risks to the Project Company in using such a structure. This mainly arises because of the derogation from the principle of single point responsibility. 5 We have prepared a paper that deals with the variations and complications in split EPC contracts in the MESA region. You should consult that paper if you want more information on this topic. Guarantor Project Company Offshore Contractor Onshore Contractor Offshore Contract Wrap-Around Guarantee Offshore Contract EPC Contracts in the oil and gas sector PwC 113 Unlike a standard EPC Contract, the Project Company cannot look only to a single Contractor to satisfy all the contractual obligations (in particular, design, construction and performance). Under a split structure, there are at least two entities with those obligations. Therefore, a third agreement, a wrap-around guarantee,6 is used to deliver a single point of responsibility despite the split. Under a wrap-around guarantee, an entity, usually either the offshore Supplier or the parent company of the contracting entities, guarantees the obligations of both Contractors. This delivers a single point of responsibility to the Project Company and the Lenders. The contracting entities will then enter into a separate agreement to determine how, as between themselves, liability is to be apportioned. However, that agreement is not relevant for the purposes of this paper. In addition, the wrap-around guarantee will, if properly drafted, prevent the various Contractors from relying on the defaults of the other parties to avoid performing their contractual obligations – a tactic known as a “horizontal defence.” The wrap-around guarantee should also prevent a Contractor from relying on the Project Company’s default where the Project Company’s default was a result, either directly or indirectly, of the nonperformance, underperformance or delay in performance of any of the other Contractors under their respective contracts. 6 Modularisation is now a common form of construction and is an example where a split EPC contract may be particularly appropriate. Guarantor Construction Contract E (an offshore entity) Onshore Guarantor Project Company B (only onshore entity) Offshore Guarantor Project Management Agreement Design Review Contract F (an offshore entity) D (an offshore entity) Equipment Supply Contract C (an offshore entity) C (an offshore entity) Design Agreement Guarantee Agreement Guarantee Agreement Wrap-Around Guarantee Sample risk register and action plan PwC 114 In addition to horizontal defences, the wrap-around guarantee should deal with the following matters:  Guarantees and indemnities: the Guarantor must guarantee the performance of the totality of the works and the ability of the separate parts to work seamlessly.  Liquidated damages: This is linked to the issue of horizontal defences discussed above. The wrap-around guarantee must ensure that liquidated damages are paid regardless of which Contractor is late and which Contractor fails to perform. Similarly, the aggregate cap of liability in the wrap-around guarantee must override any caps on liability in the split contracts themselves.  Provision of a performance bond by the Guarantor or its parent: It is usually prudent to have the Guarantor provide security for their obligations under the wrap-around guarantee. This may be in addition to or in replacement of the security provided under the EPC Contracts themselves. It will depend on the particular requirements of each project.  Liability (and limitation of liability) of the Guarantor: The Guarantor’s liability should be equal to the aggregate liability of the contracting entities under the split EPC Contracts.  Duration of the wrap-around guarantee: The wrap-around guarantee should remain in force for as long as possible to offer the Project Company additional protection in the event latent defects occur. In any event, it should remain in force until the expiry of the defects liability period or the resolution of any dispute arising out of or in connection with the construction of the facility, whichever is the later.  Dispute resolution: The procedures should be identical to those in the project documents and allow the Project Company to consolidate claims.  Termination: Termination of an EPC Contract should automatically terminate the other EPC Contract(s) and the wrap-around guarantee (except in respect of accrued liability).  Tax indemnity: Ideally the Contractor(s) should indemnify the Project Company for any taxes or penalties payable as a result of the split. In addition, the wrap-around guarantee should contain provisions dealing with the practical consequences of splitting the contract and how the contracts and the project should be administered. For example, there should also be clauses dealing with more mundane issues like notices. Notices issued under one contract should be deemed to be notices under the other contracts. Whenever an EPC Contract is split the primary driver both of the general structure of the split and the particular drafting approach must be achieving a tax-effective structure. Therefore, tax advice from experts in the relevant jurisdiction must be obtained and those experts must review the split contracts and the wraparound guarantee. Key oil – and gas-specific clauses in oil and gas EPC Contract General interface issues As noted in the previous section, an EPC Contract is one of a suite of agreements necessary to develop an oil and gas project. Therefore, it is vital that the EPC Contract properly interfaces with those other agreements. In particular, care should be taken to ensure the following issues interface properly:  commencement and completion dates  liquidated damages amounts and trigger points  caps on liability  indemnities  entitlements to extensions of time EPC Contracts in the oil and gas sector PwC 115  insurance  force majeure  intellectual property. Obviously, not all these issues will be relevant for all agreements. In addition to these general interface issues that apply to most types of projects, there are also oil and gas project issues that must be considered. These issues are many and varied and depend largely on the nature of the project. For example, on a methanol project the facility must be ready and able to accept feedstock; process it to meet rigorous occupational health, safety and environmental guidelines; and export methanol to meet Supplier and customer demands and contractual obligations. An oil project handling a light sweet crude is usually more simple. They are discussed in more detail below. Some major oil – and gas-specific interface issues are:  access for the Contractor to the feedstock and to a receiving vessel7 to allow timely completion of construction, commissioning and testing  consistency of commissioning and testing regimes8  feedstock, product and by-product (such as greenhouse emissions) specification requirements  interface issues between the relevant government agencies and System Operator and the Contractor. In particular, whilst the Project Company must maintain a long-term/comfortable relationship with either the government or the System Operator the Contractor does not. Feedstock and product storage Usually, EPC Contracts will not provide for the handover of the facility to the Project Company until all commissioning and reliability trialling has been successfully completed.8910 This raises the important issue of the supply of feedstock and other consumables (such as water) and receipt of product during testing and commissioning and the need for the EPC Contract to clearly define the obligations of the Project Company in providing feedstock and sufficient storage or product demand to fully and properly commission and test the facility. Lenders need to be able to avoid the situation where the Project Company’s obligation to ensure feedstock and storage (or demand) is uncertain. This will result in protracted disputes with the Contractor concerning the Contractor’s ability to commission and test the facility at design conditions and to obtain extensions of time in situations where delay has been caused as a result of the failure or otherwise of the Project Company to provide sufficient (or sufficient quality) feedstock or storage. 7 This is also called a coordination agreement, an administration agreement or an umbrella deed. 8 Or a sufficient source of demand. 9 Some owners will, however, carry out the commissioning themselves. 10 This sounds basic but it has been a relatively common error. The same issue arises if the testing, using this example, was contingent on another related facility being able to accept some or all of the product. Sample risk register and action plan PwC 116 With respect to the obligation to ensure the availability of sufficient feedstock, the Project Company is the most appropriate party to bear this risk vis-à-vis the Contractor, since the Project Company usually either builds the infrastructure itself or has it provided through the relevant supply agreement. Issues that must be considered include: (a) Where is the feedstock from, an existing facility or a new facility? (b) If it is a new facility, what is the timing for completion of that facility – will it fit in with the timing under the EPC Contract? What are the risks, and what can be done if it is not finished? (c) What happens if insufficient feedstock is available or not available at all? Contractors will usually want the test to be deemed complete in these circumstances. (d) What happens if the feedstock does not meet the specification? The contract should provide an adjustment mechanism to cope with this. With respect to the Contractor’s ability to export product, the EPC Contract must adequately deal with this risk and satisfactorily answer the following questions to ensure the smooth testing, commissioning and achieving commercial operation: (a) What is the extent of the product export obligation? It will usually be an obligation to provide storage or demand for the product for a fixed period of time. (b) What is the timing for the commencement of this obligation? Does the obligation cease at the relevant target date of completion? If not, does its nature change after the date has passed? (c) What is the obligation of the Project Company to provide demand or storage in cases where the Contractor’s commissioning/plant is unreliable – is it merely a reasonableness obligation? (d) What happens if the Project Company fails to provide sufficient storage or demand? Contractors will usually seek to have the test deemed complete. Many EPC Contracts are silent on these matters or raise far more questions than they actually answer. Given that the Project Company’s failure will stem from restrictions imposed on it under its supply or offtake agreements, the best answer is to back-to-back the Project Company’s obligations under the EPC Contract (usually to provide an extension of time and/or costs) with its supply and offtake agreements. This approach will not eliminate the risk associated with commissioning and testing issues but will make it more manageable. Our experience in a variety of projects has taught us that the issue of availability and quality of feedstock, and availability of storage or demand is a matter which must be resolved at the contract formation stage. Interfacing of commissioning and testing regimes It is also important to ensure the commissioning and testing regimes in the EPC Contract mirror the requirements of any supply and offtake agreements. Mismatches only result in delays, lost revenue and liability for damages under the EPC Contract, supply or offtake agreements, all of which have the potential to cause disputes. This is even more important where the EPC Contract is part of a larger development, say a methanol plant on the back of a new gas processing plant. For example, the gas processing plant might need the methanol plant to take its product as much as the methanol plant needs its product. If the interface is not carefully thought through and agreed in the contracts then this interface becomes a ripe area for disputes. Testing/trialling requirements under any related contracts must provide the necessary Project Company satisfaction under the EPC Contract and the offtake and supply contracts. Relevant testing issues which must be considered include:  Will any related facilities be required for the tests/trialling?  Is there consistency between obtaining handover from the Contractor under the EPC Contract and commercial operation. It is imperative to ensure that there is a sufficient window for the EPC Contract facility and any related facilities to be tested. Contractors will usually want an agreement that where the EPC Contracts in the oil and gas sector PwC 117 testings/trials cannot be undertaken, through no fault of its own, in a reasonable time frame the test/trials are deemed to be completed. It must not be forgotten that various certifications will be required at the Lender level. The last thing the Lenders will want is the process to be held up by their own requirements for certification. To avoid delays and disruption it is important that the Lenders’ engineer is acquainted with the details of the project and, in particular, any potential difficulties with the testing regime. Therefore, any potential problems can be identified early and resolved without impacting on the commercial operation of the facility.  Is the basis of the testing to be undertaken mirrored under both the EPC Contract and related facility? Using the methanol example above, is the gas processing plant required to produce the same quality gas that the methanol plant is to be tested/trialled, and ultimately operated on?  On what basis are various environmental tests to be undertaken?  What measurement methodology is being used? Are the correction factors to be applied under the relevant documents uniform? Are references to international standards or guidelines to a particular edition or version?  Are all tests necessary for the Contractor to complete under the EPC Contract able to be performed as a matter of practice? Significantly, if the relevant specifications are linked to guidelines such as the international environmental guidelines, consideration must be given to changes which may occur in these guidelines. The EPC Contract reflects a snapshot of the standards existing at a time when that contract was signed. It may be a number of years post that date in which the actual construction of the project is undertaken thus allowing for possible mismatches should the legislative/guidelines have changed as regards environmental concerns. It is important that there is certainty as to which standard applies. Is it the standard at the time of entering the EPC Contract or is it the standard which applies at the time of testing? Consideration must therefore be given to the appropriate mechanism to deal with potential mismatches between the ongoing obligation of complying with laws and the Contractor’s obligation to build to a specification agreed at a previous time. Consideration must be given to requiring satisfaction of guidelines as “amended from time to time13.” The breadth of any change of law provision will be at the forefront of any review. The above issues raise the importance of the testing schedules to the EPC Contract. The size and importance of the various projects to be undertaken must mean that the days where schedules are attached at the last minute without being subject to review are gone as they are part and parcel of the EPC Contract. Discrepancies between the relevant testing and commissioning requirements will only serve to delay and distract all parties from the successful completion of testing and reliability trials. These are all areas where lawyers can add value to the successful completion of projects by being alert to and dealing with such issues at the contract formation stage. Feedstock specification issues The nature of the feedstock to be supplied to the Contractor under the EPC Contract is also another important issue. Where there is a supply agreement1314 it is vitally important that adequate review is done at the EPC Contract level to ensure that the feedstock being provided under the supply agreement meets the requirements of the EPC Contract. Similar consideration will need to be given to any Project Company where it will be 11 It is often the case that if amendments to the design are required as a result the contractor will be entitled to extensions of time and/or variations. 12 As opposed to the situations of the operator of the new plant also supplying the feedstock, which presents its own problems. 13 This can be in the form of steady state testing. 14 It can be termed that handover will not occur until the performance guarantees are met and there will be a regime by which this may be waived. Sample risk register and action plan PwC 118 supplying the feedstock itself. This is a common area of dispute where the facility fails to meet the specification in test/trials. Differing feedstock specification requirements can only result in delay, cost claims and extension of time claims at the EPC Contract level. Feedstock specification issues will be hidden away in the schedules. Again, watch out for those schedules. In addition, where certain tests require specific types or quality of feedstock the review should check that there are arrangements in place for that type of quality of feedstock to be provided. If the specification calls for a wide range of feedstock and provision is made for it to be tested as such, it will be meaningless if the test cannot be undertaken. For example, the production plan might show an increase in a certain contaminant over the life of the project so a test on the lower quality feedstock may be appropriate, but only if it is possible to do so. Interface issues between a supply or Offtaker and the EPC Contractor At a fundamental level, it is imperative that the appropriate party corresponds with the relevant Supplier or Offtaker/System Operator during construction on issues such as the provision of offtake facilities/feedstock requirements/testing requirements and timing. The Project Company must ensure the EPC Contract states clearly that it is the appropriate party to correspond with the Supplier or Offtaker and the System Operator. Any uncertainty in the EPC Contract may unfortunately see the EPC Contractor dealing with the Supplier or Offtaker and/or the System Operator thus possibly risking the relationship of the Project Company with its customer. Significantly, it is the Project Company which must develop and nurture an ongoing and long-term relationship with the Offtaker. On the other hand, it is the Contractor’s prime objective to complete the project on time or earlier at a cost which provides it with significant profit. The clash of these conflicting objectives in many cases does not allow for such a smooth process. Again, the resolution of these issues at the EPC Contract formation stage is imperative. Key Performance clauses in oil and gas EPC Contract Rationale for imposing liquidated damages Almost every construction contract will impose liquidated damages for delay and impose standards in relation to the quality of construction. Most, however, do not impose PLDs. EPC Contracts impose PLDs because the achievement of the performance guarantees has a significant impact on the ultimate success of a project. Similarly, it is important that the facility commences operation on time because of the impact on the success of the project and because of the liability the Project Company will have under other agreements. This is why DLDs are imposed. DLDs and PLDs are both sticks used to motivate the Contractor to fulfil its contractual obligations. The law of liquidated damages As discussed above, at common law liquidated damages must be a genuine pre-estimate of the Project Company’s loss. If liquidated damages are more than a genuine pre-estimate they will be a penalty and unenforceable. There is no legal sanction for setting a liquidated damages rate below that of a genuine preestimate, however, there are the obvious financial consequences. In addition to being unenforceable as a penalty, liquidated damages can also be void for uncertainty or unenforceable because they breach the Prevention Principle. Void for uncertainty means, as the term suggests, that it is not possible to determine how the liquidated provisions work. In those circumstances, a court will void the liquidated damages provisions. The Prevention Principle was developed by the courts to prevent Employers ie Project Companies from delaying Contractors and then claiming DLDs. It is discussed in more detail below in the context of extensions of time. Prior to discussing the correct drafting of liquidated damages clauses to ensure they are not void or unenforceable, it is worth considering the consequences of an invalid liquidated damages regime. If the EPC Contract contains an exclusive remedies clause the result is simple – the Contractor will have escaped liability unless the contract contains an explicit right to claim damages at law if the liquidated damages regime fails. EPC Contracts in the oil and gas sector PwC 119 If, however, the EPC Contract does not contain an exclusive remedies clause the non-challenging party should be able to claim at law for damages they have suffered as a result of the challenging party’s non-defective or defective performance. What then is the impact of the caps in the now invalidated liquidated damages clauses? Unfortunately, the position is unclear in common law jurisdictions and a definitive answer cannot be provided based upon the current state of authority. It appears the answer varies depending upon whether the clause is invalidated due to its character as a penalty, or because of uncertainty or unenforceability. Our view of the current position is set out below. We note that whilst the legal position is not settled the position presented below does appear logical. Clause invalidated as a penalty: When liquidated damages are invalidated because they are a penalty (ie they do not represent a genuine pre-estimate of loss), the cap on liquidated damages will not act as a cap on damages claims at general law. We note that it is rare for a court to find liquidated damages are penalties in contracts between two sophisticated, well-advised parties. Clause invalidated due to acts of prevention by the Principal: Where a liquidated damages clause is invalidated due to an act of prevention by the Principal for which the Contractor is not entitled to an extension of time, the liquidated damages or its cap will not act as a cap on damages claims at general law. Clause void for uncertainty: A liquidated damages clause which is unworkable or too uncertain to ascertain what the parties intended is severed from the EPC Contract in its entirety, and will not act as a cap on the damages recoverable by the Principal from the Contractor. Upon severance, the clause is, for the purposes of contractual interpretation, ignored. However, it should be noted that the threshold test for rendering a clause void for uncertainty is high, and courts are reluctant to hold that the terms of a contract, in particular a commercial contract where performance is well advanced, are uncertain. Drafting of liquidated damages clauses Given the role liquidated damages play in ensuring EPC Contracts are bankable, and the consequences detailed above of the regime not being effective, it is vital to ensure they are properly drafted to ensure Contractors cannot avoid their liquidated damages liability on a legal technicality. Therefore, it is important, from a legal perspective, to ensure DLDs and PLDs are dealt with separately. If a combined liquidated damages amount is levied for late completion of the works, it risks being struck out as a penalty because it will overcompensate the Project Company. However, a combined liquidated damages amount levied for underperformance may undercompensate the Project Company. Our experience shows that there is a greater likelihood of delayed completion than there is of permanent underperformance. One of the reasons why projects are not completed on time is Contractors are often faced with remedying performance problems. This means, from a legal perspective, if there is a combination of DLDs and PLDs, the liquidated damages rate should include more of the characteristics of DLDs to protect against the risk of the liquidated damages being found to be a penalty. If a combined liquidated damages amount includes an NPV or performance element the Contractor will be able to argue that the liquidated damages are not a genuine pre-estimate of loss when liquidated damages are levied for late completion only. However, if the combined liquidated damages calculation takes on more of the characteristics of DLDs the Project Company will not be properly compensated if there is permanent underperformance. Sample risk register and action plan PwC 120 Where there is significant under-performance such as a failure to meet the minimum performance guarantees, an EPC contract will generally provide for remedies other than the payments of PLDs. For example, the range of remedies usually included in an EPC contract in relation to the minimum performance guarantees not being met are:  The contractor is required to replace the facility or any part of the facility and repeating the performance tests until the minimum performance guarantees are met  Termination of the contract with the project company completing the facility or engaging a third party to do so  Rejection of the facility or part of the facility in which case the contractor must repay all sums paid by the project company and the cost of dismantling and clearing the facility or part of the facility  Issuing a certificate of completing despite the contractor not meeting the minimum performance guarantees with a corresponding reduction in the contract price. It is also important to differentiate between the different types of PLDs to protect the Project Company against arguments by the Contractor that the PLDs constitute a penalty. For example, if a single PLDs rate is only focused on output and not efficiency, problems and uncertainties will arise if the output guarantee is met but one or more of the efficiency guarantees are not. In these circumstances, the Contractor will argue that the PLDs constitute a penalty because the loss the Project Company suffers if the efficiency guarantees are not met are usually smaller than if the output guarantees are not met. Drafting of the performance guarantee regime Now that it is clear that DLDs and PLDs must be dealt with separately it is worth considering, in more detail, how the performance guarantee regime should operate. A properly drafted performance testing and guarantee regime is important because the success or failure of the project depends, all other things being equal, on the performance of the oil and gas facility. The major elements of the performance regime are:  testing  guarantees  liquidated damages Liquidated damages were discussed above. Testing and guarantees are discussed below. Testing Performance tests may cover a range of areas. Three of the most common are: Functional tests: These test the functionality of certain parts of the facility. For example, pumps, valves, pressure vessels etc. They are usually discrete tests which do not test the facility as a whole. Liquidated damages do not normally attach to these tests. Instead, they are absolute obligations that must be complied with. If not, the facility will not reach the next stage of completion (for example, mechanical completion or provisional acceptance). Emissions tests: These test compliance against environmental requirements. Again, these are normally absolute obligations because the consequences of failure can be as severe as being forced to shut down the facility. These tests should ensure the most stringent obligations imposed on the Project Company, whether by government regulations or by Lenders, are met. Emissions tests occur at various times, including during and after guarantee tests. Liquidated damages are sometimes levied if the Contractor fails the emissions tests. However, given emissions tests are usually related to environmental approvals, it is likely that the facility will not be able to operate if the emissions tests are failed. Therefore, passing the emissions tests is usually an absolute obligation not linked to liquidated damages. EPC Contracts in the oil and gas sector PwC 121 Guarantee tests: These test the ability of the facility to meet the performance criteria specified in the contract. There are often minimum and guaranteed levels of performance specified and, as discussed above, providing the minimum levels are met the consequence of failure is normally the payment of PLDs. Satisfaction of the minimum performance guarantees12 is normally an absolute obligation. The minimum performance guarantees should be set at a level of performance at which it is economic to accept the facility. Lenders’ input will be vital in determining this level. However, it must be remembered that Lenders have different interests to the Sponsors. Lenders will, generally speaking, be prepared to accept a facility that provides sufficient income to service the debt. However, in addition to covering the debt service obligations, Sponsors will also want to receive a return on their equity investment. If that will not be provided via the sale of product because the Contractor has not met the performance guarantees, the Sponsors will have to rely on the PLDs to earn their return. In some projects, the guarantee tests occur after handover of the facility to the Project Company. This means the Contractor no longer has any liability for DLDs during performance testing. In our view, it is preferable, especially on project-financed projects, for handover to occur after completion of performance testing. This means the Contractor continues to be liable for DLDs until either the facility operates at the guaranteed level or the Contractor pays PLDs where the facility does not operate at the guaranteed level. Obviously, DLDs will be capped (usually at 20 percent of the contract price) therefore, the EPC Contract should give the Project Company the right to call for the payment of the PLDs and accept the facility. If the Project Company does not have this right the problem mentioned above will arise, namely, the Project Company will not have received its facility and will not be receiving any DLDs as compensation. It is common for the Contractor to be given an opportunity to modify the facility if it does not meet the performance guarantees on the first attempt. This is because the PLD amounts are normally very large and most Contractors would prefer to spend the time and the money necessary to remedy performance instead of paying PLDs. Not giving Contractors this opportunity will likely lead to an increased contract price both because Contractors will over-engineer the facility and will build a contingency for paying PLDs into the contract price. The second reason is because in most circumstances the Project Company will prefer to receive a facility that operates at 100 per cent capacity and efficiency. The right to modify and retest is another reason why DLDs should be payable up to the time the performance guarantees are satisfied. If the Contractor is to be given an opportunity to modify and retest the EPC Contract must deal with who bears the costs of the additional feedstock and consumables required to undertake the retesting. The cost of the feedstock in particular can be significant and should, in normal circumstances, be to the Contractor’s account because the retesting only occurs if the performance guarantees are not met at the first attempt. Technical issues Ideally, the technical testing procedures should be set out in the EPC Contract. However, for a number of reasons, including the fact that it is often not possible to fully scope the testing programme until the detailed design is complete, the testing procedures are usually left to be agreed during construction by the Contractor, the Project Company’s representative or engineer and, if relevant, the Lenders’ engineer. However, a properly drafted EPC Contract should include the guidelines for testing. 15 It can arise in civil law countries as well, it will depend on the relevant provisions of the code in those countries. For example, the UAE Civil Code contains a number of articles that entitle a contractor to an extension of time for employer-caused delays. For further information on liability in EPC contracts under Australian law, refer to our paper entitled "Position Paper on Liability". 16 The critical path is the path on the construction programme that shows the dates when certain activities must be completed by in order to achieve completion by the specified date. Sample risk register and action plan PwC 122 Performance Guarantees and Testing The complete testing procedures must, as a minimum, set out details of:  Testing methodology: Reference is often made to standard methodologies, for example, the American Society of Mechanical Engineers methodology.  Testing equipment: Who is to provide it, where it is to be located, how sensitive must it be. The Plant has or is deemed to have reached Mechanical Completion Contractor commences Functional Tests, Emission Test and Performance Tests Has any of the Functional Tests, Emission Tests or Performance Tests been interrupted or terminated for any reason Particular Functional Tests, Emission Tests or Performance Tests must be restarted Did Owner’s Representative or Contractor order cessation of Functional Tests, Emission Tests or Performance Tests due to damage to the Works, other property or personal injury being likely to result from continuation? Has the Plant failed to pass any of the Functional Tests, Emission Test or Performance Tests or have any such Tests been stopped before its completion? Contractor must repeat particular Functional Tests. Emission Tests and Performance Tests, subject to 24 hours prior notice from Contractor to Owner’s Representative All appropriate adjustments and modifications to be made by Contractor with all reasonable speed and at its own expense prior to repetition of any Functional Tests, Emission Tests and Performance Tests Contractor must produce and present written report of results of the Functional Tests, Emission Tests and Performance Tests within seven days of completion of the Functional Tests, Emission Tests and Performance Tests Owner’s Representative must evaluate and approve results with no allowance for measurement tolerances over and above the ISO test standard Contractor to pay appropriate Performance Liquidated Damages Contractor to pay full Delay Liquidated Damages cap Have the Minimum Performance Guarantees been met before a reaching the cap on the Delay Liquidated Damages? Has the Owner issued a Substantial Completion Certification even though all of the requirements have not been met? Has the Minimum Rated Output Performance Guarantee and the Minimum Net Heat Rate Performance Guarantee been met during Performance Tests? Has the Rated Output Performance Guarantee been met during Performance Tests? Has the Contractor elected to pay Performance Liquidated Damages, before the expiry of the Extended Testing Period? Has the Owner required the Contractor to pay Performance Liquidated Damages, before the expiry of the Extended Testing Period? Has the Maximum Rated Output Performance Guarantees been met before the expiry of the Extended Testing Period? Contractor to pay pro rata Delay Liquidated Damages and Owner to issue Substantial Completion Certificate Contractor pay full Delay Liquidated Damages (cap value) and appropriate Performance Liquidated Damages and owner to issue Substantial Completion Certificate Contractor to pay pro rata Delay Liquidated Damages and appropriate Performance Liquidated Damages and Owner to issue Substantial Completion Certificate Completion No Yes Yes No No No No No And Yes Yes No No No Yes Yes Yes Yes EPC Contracts in the oil and gas sector PwC 123  Tolerances: What is the margin of error.  Ambient conditions: What atmospheric conditions are assumed to be the base case (testing results will need to be adjusted to take into account any variance from these ambient conditions).  Steady state testing: Using ordinary parameters to avoid running the plant at unsustainable shortterm rates. Provision of consumables and feedstock The responsibility for the provision of consumables and feedstock required to carry out the performance tests must be clearly set out in the EPC Contract. In general, the Project Company will be responsible for the provision of both consumables and feedstock. As the proper interpretation of the Project Company’s obligation to supply consumables is often a matter of dispute between the Project Company and Contractor, it is important for the EPC Contract to precisely identify the quality and quantity of consumables to be provided as well as the time for provision of those consumables (which should be linked to the progress of the works rather than a specific date). The responsibility for the cost of providing consumables and feedstock must also be clearly identified. This is discussed in more detail in the section on feedstock specification issues. An example of the performance testing and guarantee regime we have used on a number of projects is included in Appendix 1 of this paper. These example clauses are only extracts from a complete contract and ideally should be read as part of that entire contract and, in particular, with the clauses that deal with DLDs, PLDs, liability, the scope of the Contractor’s obligations, including any fitness for purpose warranties and termination. Nonetheless, they do provide an example of the way a performance testing and liquidated damages regime can operate. The process is best illustrated diagrammatically. Refer to the flowchart below to see how the various parts of the performance testing regime should interface. Delay and extensions of time in EPC Contract Delay and extensions of time The Prevention Principle As noted previously, one of the advantages of an EPC Contract is that it provides the Project Company with a fixed completion date. If the Contractor fails to complete the works by the required date it is liable for DLDs. However, in some circumstances the Contractor is entitled to an extension of the date for completion. Failure to grant that extension can void the liquidated damages regime and set time at large. This means the Contractor is only obliged to complete the works within a reasonable time. This is the situation under common law-governed contracts 14due to the Prevention Principle. The Prevention Principle was developed by the courts to prevent Employers ie Project Companies from delaying Contractors and then claiming DLDs. The legal basis of the Prevention Principle is unclear and it is uncertain whether you can contract out of the Prevention Principle. Logically, given most commentators believe the Prevention Principle is an equitable principle, explicit words in a contract should be able to override the principle. However, the courts have tended to apply the Prevention Principle even in circumstances where it would not, on the face of it, appear to apply. Therefore, there is a certain amount of risk involved in trying to contract out of the Prevention Principle. The more prudent and common approach is to accept the existence of the Prevention Principle and provide for it the EPC Contract. The Contractor’s entitlement to an extension of time is not absolute. It is possible to limit the Contractor’s rights and impose pre-conditions on the ability of the Contractor to claim an extension of time. A relatively standard extension of time (EOT) clause would entitle the Contractor to an EOT for: Sample risk register and action plan PwC 124  an act, omission, breach or default of the Project Company  suspension of the works by the Project Company (except where the suspension is due to an act or omission of the Contractor)  a variation (except where the variation is due to an act or omission of the Contractor)  force majeure. which cause a delay on the critical path15 and about which the Contractor has given notice within the period specified in the contract. It is permissible (and advisable) to make both the necessity for the delay to impact the critical path and the obligation to give notice of a claim for an extension of time conditions precedent to the Contractor’s entitlement to receive an EOT. In addition, it is usually good practice to include a general right for the Project Company to grant an EOT at any time. However, this type of provision must be carefully drafted because some judges have held (especially when the Project Company’s representative is an independent third party) the inclusion of this clause imposes a mandatory obligation on the Project Company to grant an extension of time whenever it is fair and reasonable to do so, regardless of the strict contractual requirements. It must be made clear that the Project Company has complete and absolute discretion to grant an EOT and that it is not required to exercise its discretion for the benefit of the Contractor. Similarly, following some recent common law decisions, the Contractor should warrant that it will comply with the notice provisions that are conditions precedent to its right to be granted an EOT. We recommend using the clause in part 2 of Appendix 1. Concurrent delay You will note that in the suggested EOT clause, one of the subclauses refers to concurrent delays. This is relatively unusual because most EPC Contracts are silent on this issue. For the reasons explained below we do not agree with that approach. A concurrent delay occurs when two or more causes of delay overlap. It is important to note that it is the overlapping of the causes of the delays not the overlapping of the delays themselves. In our experience, this distinction is often not made. This leads to confusion and sometimes disputes. More problematic is when the contract is silent on the issue of concurrent delay and the parties assume the silence operates to their benefit. As a result of conflicting case law it is difficult to determine who, in a particular fact scenario, is correct. This can also lead to protracted disputes and outcomes contrary to the intention of the parties. There are a number of different causes of delay which may overlap with delay caused by the Contractor. The most obvious causes are the acts or omissions of a Project Company. A Project Company may have obligations to provide certain materials or infrastructure to enable the Contractor to complete the works. The timing for the provision of that material or infrastructure (and the consequences for failing to provide it) can be affected by a concurrent delay. For example, the Project Company may be obliged, as between the Project Company and the Contractor, to provide a pipeline or vessel to connect to the facility by the time the Contractor is ready to commission the facility. Given the construction of the pipeline or the chartering of a vessel can be expensive, the Project Company is likely to want to incur that expense as close as possible to the date commissioning is due to commence. For this reason, if the Contractor is in delay the Project Company is likely to further delay incurring the expense of building the pipeline or chartering the vessel. In the absence of a concurrent delay clause, this action by the Project Company, in response to the Contractor’s delay, could entitle the Contractor to an extension of time. Concurrent delay is dealt with differently in the various international standard forms of contract. Accordingly, it is not possible to argue that one approach is definitely right and one is definitely wrong. In fact, the right approach will depend on which side of the table you are sitting. EPC Contracts in the oil and gas sector PwC 125 In general, there are three main approaches for dealing with the issue of concurrent delay. These are:  Option one: The Contractor has no entitlement to an extension of time if a concurrent delay occurs.  Option two: The Contractor has an entitlement to an extension of time if a concurrent delay occurs.  Option three: The causes of delay are apportioned between the parties and the Contractor receives an extension of time equal to the apportionment. For example, if the causes of a 10-day delay are apportioned 60:40 Project Company:Contractor, the Contractor would receive a six-day extension of time. Each of these approaches is discussed in more detail below. Option one: Contractor not entitled to an extension of time for concurrent delays A common, Project Company-friendly, concurrent delay clause for this option one is: If more than one event causes concurrent delays and the cause of at least one of those events, but not all of them, is a cause of delay which would not entitle the Contractor to an extension of time under [EOT clause], then to the extent of the concurrency, the Contractor will not be entitled to an extension of time. The most relevant words are in bold. Nothing in the clause prevents the Contractor from claiming an extension of time under the general extension of time clause. What the clause does do is to remove the Contractor’s entitlement to an extension of time when there are two or more causes of delay and at least one of those causes would not entitle the Contractor to an extension of time under the general extension of time clause. For example, if the Contractor’s personnel were on strike and during that strike the Project Company failed to approve drawings, in accordance with the contractual procedures, the Contractor would not be entitled to an extension of time for the delay caused by the Project Company’s failure to approve the drawings. The operation of this clause is best illustrated diagrammatically. Example 1: Contractor not entitled to an extension of time for Project Company-caused delay In this example, the Contractor would not be entitled to any extension of time because the Contractor Delay 2 overlaps entirely the Project Company Delay. Therefore, using the example clause above, the Contractor is not entitled to an extension of time to the extent of the concurrency. As a result, at the end of the Contractor Delay 2 the Contractor would be in eight weeks’ delay (assuming the Contractor has not, at its own cost and expense, accelerated the works). Example 2: Contractor entitled to an extension of time for Project Company-caused delay In this example, there is no overlap between the Contractor and Project Company Delay Events where the Contractor would be entitled to a two-week extension of time for the Project Company Delay. Therefore, at the end of the Project Company Delay the Contractor will remain in six weeks’ delay, assuming no acceleration. Project Company Delay Contractor Delay 1 Contractor Delay 2 6 weeks 2 weeks 1 week Sample risk register and action plan PwC 126 Example 3: Contractor entitled to an extension of time for a portion of the Project Companycaused delay In this example, the Contractor would be entitled to a one-week extension of time because the delays overlap for one week. Therefore, the Contractor is entitled to an extension of time for the period when they do not overlap ie when the extent of the concurrency is zero. As a result, after receiving the one-week extension of time, the Contractor would be in seven weeks’ delay, assuming no acceleration. From a Project Company’s perspective, we believe, this option is both logical and fair. For example, if, in example 2, the Project Company Delay was a delay in the approval of drawings and the Contractor Delay was the entire workforce being on strike, what logic is there in the Contractor receiving an extension of time? The delay in approving drawings does not actually delay the works because the Contractor could not have used the drawings given its workforce was on strike. In this example, the Contractor would suffer no detriment from not receiving an extension of time. However, if the Contractor did receive an extension of time it would effectively receive a windfall gain. The greater number of obligations the Project Company has the more reluctant the Contractor will likely be to accept option one. Therefore, it may not be appropriate for all projects. Option two: Contractor entitled to an extension of time for concurrent delays Option two is the opposite of option one and is the position in many of the Contractor-friendly standard forms of contract. These contracts also commonly include extension of time provisions to the effect that the Contractor is entitled to an extension of time for any cause beyond its reasonable control which, in effect, means there is no need for a concurrent delay clause. The suitability of this option will obviously depend on which side of the table you are sitting. This option is less common than option one but is nonetheless sometimes adopted. It is especially common when the Contractor has a superior bargaining position. Project Contractor Delay Event Contractor Delay Event 6 weeks 2 weeks Delay Project Company Delay Contractor Delay 1 Contractor Delay 2 6 weeks 2 weeks 2 weeks EPC Contracts in the oil and gas sector PwC 127 Option three: Responsibility for concurrent delays is apportioned between the parties Option three is a middle ground position that has been adopted in some of the standard form contracts. For example, the Australian Standards construction contract AS4000 adopts the apportionment approach. The AS4000 clause states: 34.4 Assessment When both non-qualifying and qualifying causes of delay overlap, the Superintendent shall apportion the resulting delay to WUC according to the respective causes’ contribution. In assessing each EOT the Superintendent shall disregard questions of whether: a) WUC can nevertheless reach practical completion without an EOT; or b) the Contractor can accelerate, but shall have regard to what prevention and mitigation of the delay has not been effected by the Contractor. We appreciate the intention behind the clause and the desire for both parties to share responsibility for the delays they cause. However, we have some concerns about this clause and the practicality of the apportionment approach in general. It is easiest to demonstrate our concerns with an extreme example. For example, what if the qualifying cause of delay was the Project Company’s inability to provide access to the site and the nonqualifying cause of delay was the Contractor’s inability to commence the works because it had been black banned by the unions. How should the causes be apportioned? In this example, the two causes are both 100 percent responsible for the delay. In our view, an example like the above where both parties are at fault has two possible outcomes. Either:  the delay is split down the middle and the Contractor receives 50 percent of the delay as an extension of time  the delay is apportioned 100 percent to the Project Company and therefore the Contractor receives 100 percent of the time claimed. The delay is unlikely to be apportioned 100 percent to the Contractor because a judge or arbitrator will likely feel that that is unfair, especially if there is a potential for significant liquidated damages liability. We appreciate the above is not particularly rigorous legal reasoning, however, the clause does not lend itself to rigorous analysis. In addition, option three is only likely to be suitable if the party undertaking the apportionment is independent from both the Project Company and the Contractor. Exclusive remedies and fail-safe clauses It is common for Contractors to request the inclusion of an exclusive remedies clause in an EPC Contract. However, from the perspective of a Project Company, the danger of an exclusive remedies clause is that it prevents the Project Company from recovering any type of damages not specifically provided for in the EPC Contract. An EPC Contract is conclusive evidence of the agreement between the parties to that contract. If a party clearly and unambiguously agrees that its only remedies are those within the EPC Contract, it will be bound by those terms. However, the courts have been reluctant to come to this conclusion without clear evidence of an intention of the parties to the EPC Contract to contract out of their legal rights. This means if the common law right to sue for breach of the EPC Contract is to be contractually removed, it must be done by very clear words. Contractor’s perspective The main reason for a Contractor insisting on a Project Company being subject to an exclusive remedies clause is to have certainty about its potential liabilities. The preferred position for a Contractor will be to confine its liabilities to what is specified in the EPC Contract. For example, an agreed rate of liquidated damages for delay Sample risk register and action plan PwC 128 and, where relevant, underperformance of the facility. A Contractor will also generally require the amount of liquidated damages to be subject to a cap and for the EPC Contract to include an overall cap on its liability. Project company’s perspective The preferred position for a Project Company is for it not to be subject to an exclusive remedies clause. An exclusive remedies clause limits the Project Company’s right to recover for any failure of the Contractor to fulfil its contractual obligations to those remedies specified in the EPC Contract. For this reason, an exclusive remedies clause is an illogical clause to include in an EPC Contract from the perspective of a Project Company because it means that the Project Company has to draft a remedy or exception for each obligation – this represents an absurd drafting position. For example, take the situation where the EPC Contract does not have any provision for the recovery of damages other than liquidated damages. In this case, if the Contractor has either paid the maximum amount of liquidated damages or delivered the facility in a manner that does not require the payment of liquidated damages (ie it is delivered on time and performs to specification) but subsequent to that delivery the Project Company is found to have a claim, say for defective design which manifests itself after completion, the Project Company will have no entitlement to recover any form of damages as any remedy for latent defects has been excluded. The problem is exacerbated because most claims made by a Project Company will in some way relate to performance of the facility and PLDs were expressed to be the exclusive remedy for any failure of the facility to perform in the required manner. For example, any determination as to whether the facility is fit for purpose will necessarily depend on the level and standard of the performance of the facility. In addition to claims relating to fitness for purpose, a Project Company may also wish to make claims for, amongst other things, breach of contract, breach of warranty or negligence. The most significant risk for a Project Company in an EPC Contract is where there is an exclusive remedies clause and the only remedies for delay and underperformance are liquidated damages. If, for whatever reason, the liquidated damages regimes are held to be invalid, the Project Company would have no recourse against the Contractor as it would be prevented from recovering general damages at law and the Contractor would escape liability for late delivery and underperformance of the facility. Fail-safe clauses In contracts containing an exclusive remedies clause, the Project Company must ensure all necessary exceptions are expressly included in the EPC Contract. In addition, drafting must be included to allow the Project Company to recover general damages at law for delay and underperformance if the liquidated damages regimes in the EPC Contract are held to be invalid. To protect the position of a Project Company (if liquidated damages are found for any reason to be unenforceable and there is an exclusive remedies clause), we recommend the following clauses be included in the EPC Contract: [ ].1 If clause [delay liquidated damages] is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Project Company from claiming delay liquidated damages, the Project Company is entitled to claim against the Contractor damages at law for the Contractor’s failure to complete the works by the date for practical completion. [ ].2 If [ ].1 applies, the damages claimed by the Project Company must not exceed the amount specified in Item [ ] of Appendix [ ] for any one day of delay and in aggregate must not exceed the percentage of the EPC Contract price specified in item [ ] of Appendix [ ]. These clauses (which would also apply to PLDs) mean that if liquidated damages are held to be unenforceable for any reason the Project Company will not be prevented from recovering general damages at law. However, the amount of damages recoverable at law may be limited to the amount of liquidated damages that would have been recoverable by the Project Company under the EPC Contract if the liquidated damages regime had not been held to be invalid. For this reason, the suggested drafting should be commercially acceptable to a Contractor as its liability for delay and underperformance will be the same as originally contemplated by the parties at the time of entering into the EPC Contract. In addition, if the EPC Contract excludes the parties’ rights to claim their consequential or indirect losses, these clauses should be an exception to that exclusion. The rationale being that the rates of liquidated damages are likely to include an element of consequential or indirect losses. EPC Contracts in the oil and gas sector PwC 129 Force Majeure What is force majeure? Force majeure clauses are almost always included in EPC Contracts. However, they are rarely given much thought unless and until one or more parties seek to rely on them. Generally, the assumption appears to be that “the risk will not affect us” or “the force majeure clause is a legal necessity and does not impact on our risk allocation under the contract.” Both of these assumptions are inherently dangerous, and, particularly in the second case, incorrect. Therefore, especially in the current global environment, it is appropriate to examine their application. Force majeure is a civil law concept that has no real meaning under the common law. However, force majeure clauses are used in contracts because the only similar common law concept – the doctrine of frustration – is of limited application. For that doctrine to apply the performance of a contract must be radically different from what was intended by the parties. In addition, even if the doctrine does apply, the consequences are unlikely to be those contemplated by the parties. An example of how difficult it is to show frustration is that many of the leading cases relate to the abdication of King Edward VIII before his coronation and the impact that had on contracts entered into in anticipation of the coronation ceremony. Given force majeure clauses are creatures of contract their interpretation will be governed by the normal rules of contractual construction. Force majeure provisions will be construed strictly and in the event of any ambiguity the contra proferentem rule will apply. Contra proferentem literally means ”against the party putting forward”. In this context, it means that the clause will be interpreted against the interests of the party that drafted and is seeking to rely on it. The parties may contract out of this rule. The rule of ejusdem generis which literally means “of the same class” may also be relevant. In other words, when general wording follows a specific list of events, the general wording will be interpreted in light of the specific list of events. In this context it means that when a broad catch-all phrase, such as “anything beyond the reasonable control of the parties,” follows a list of more specific force majeure events the catch-all phrase will be limited to events analogous to the listed events. Importantly, parties cannot invoke a force majeure clause if they are relying on their own acts or omissions. The underlying test in relation to most force majeure provisions is whether a particular event was within the contemplation of the parties when they made the contract. The event must also have been outside the control of the contracting party. There are generally three essential elements to force majeure:  it can occur with or without human intervention  it cannot have reasonably been foreseen by the parties  it was completely beyond the parties’ control and they could not have prevented its consequences Given the relative uncertainty surrounding the meaning of force majeure we favour explicitly defining what the parties mean. This takes the matter out of the hands of the courts and gives control back to the parties. Therefore, it is appropriate to consider how force majeure risk should be allocated. Drafting force majeure clauses The appropriate allocation of risk in project agreements is fundamental to negotiations between the Project Company and its Contractors. Risks generally fall into the following categories:  risks within the control of the Project Company  risks within the control of the Contractor  risks outside the control of both parties The negotiation of the allocation of many of the risks beyond the control of the parties, for example, latent site conditions and change of law, is usually very detailed so that it is clear which risks are borne by the Contractor. The same approach should be adopted in relation to the risks arising from events of force majeure. Sample risk register and action plan PwC 130 There are two aspects to the operation of force majeure clauses:  the definition of force majeure events  the operative clause that sets out the effect on the parties’ rights and obligations if a force majeure event occurs.1617 The events which trigger the operative clause must be clearly defined. As noted above, given the common law meaning of the term force majeure is not certain and is open to interpretation of the courts, it is in the interests of both parties to ensure that the term force majeure is clearly defined. The preferred approach for a Project Company is to define force majeure events as being any of the events in an exhaustive list set out in the contract. In this manner, both parties are aware of which events are force majeure events and which are not. Clearly, defining force majeure events makes the administration of the contract and, in particular, the mechanism within the contract for dealing with force majeure events simpler and more effective. An example exhaustive definition is: An event of force majeure is an event or circumstance which is beyond the control and without the fault or negligence of the party affected and which by the exercise of reasonable diligence the party affected was unable to prevent provided that event or circumstance is limited to the following: (a) riot, war, invasion, act of foreign enemies, hostilities (whether war be declared or not), acts of terrorism, civil war, rebellion, revolution, insurrection of military or usurped power, requisition or compulsory acquisition by any governmental or competent authority (b) ionising radiation or contamination, radioactivity from any nuclear fuel or from any nuclear waste from the combustion of nuclear fuel, radioactive, toxic, explosive or other hazardous properties of any explosive assembly or nuclear component (c) pressure waves caused by aircraft or other aerial devices travelling at sonic or supersonic speeds (d) earthquakes, flood, fire or other physical natural disaster, but excluding weather conditions regardless of severity (e) strikes at national level or industrial disputes at a national level, or strike or industrial disputes by labour not employed by the affected party, its sub contractors or its Suppliers and which affect an essential portion of the works but excluding any industrial dispute which is specific to the performance of the works or this contract. An operative clause will act as a shield for the party affected by the event of force majeure so that a party can rely on that clause as a defence to a claim that it has failed to fulfil its obligations under the contract. An operative clause should also specifically deal with the rights and obligations of the parties if a force majeure event occurs and affects the project. This means the parties must consider each of the events it intends to include in the definition of force majeure events and then deal with what the parties will do if one of those events occurs. 17 A common failing of force majeure in some negotiations is to focus on the definitional issues rather than the consequences. Both issues are important. EPC Contracts in the oil and gas sector PwC 131 An example of an operative clause is: [ ].1 Neither party is responsible for any failure to perform its obligations under this contract, if it is prevented or delayed in performing those obligations by an event of force majeure. [ ].2 Where there is an event of force majeure, the party prevented from or delayed in performing its obligations under this contract must immediately notify the other party giving full particulars of the event of force majeure and the reasons for the event of force majeure preventing that party from, or delaying that party in performing its obligations under this contract and that party must use its reasonable efforts to mitigate the effect of the event of force majeure upon its or their performance of the contract and to fulfil its or their obligations under the contract. [ ].3 Upon completion of the event of force majeure the party affected must as soon as reasonably practicable recommence the performance of its obligations under this contract. Where the party affected is the Contractor, the Contractor must provide a revised programme rescheduling the works to minimise the effects of the prevention or delay caused by the event of force majeure. [ ].4 An event of force majeure does not relieve a party from liability for an obligation which arose before the occurrence of that event, nor does that event affect the obligation to pay money in a timely manner which matured prior to the occurrence of that event. [ ].5 The Contractor has no entitlement and the Project Company has no liability for: (a) any costs, losses, expenses, damages or the payment of any part of the contract price during an event of force majeure (b) any delay costs in any way incurred by the Contractor due to an event of force majeure. In addition to the above clause, it is critical to appropriately deal with other issues that will arise if a force majeure event occurs. For example, as noted above, it is common practice for a Contractor to be entitled to an extension of time if a force majeure event impacts on its ability to perform the works. Contractors also often request costs if a force majeure event occurs. In our view, this should be resisted. Force majeure is a neutral risk in that it cannot be controlled by either party. Therefore, the parties should bear their own costs and neither party should be penalised. Another key clause that relates to force majeure type events is the Contractor’s responsibility for care of the works and the obligation to reinstate any damage to the works prior to completion. A common example clause is: [ ].1 The Contractor is responsible for the care of the site and the works from when the Project Company makes the site available to the Contractor until 5.00pm on the date of commercial operation. [ ].2 The Contractor must promptly make good loss from, or damage to, any part of the site and the works while it is responsible for their care. [ ].3 If the loss or damage is caused by an event of force majeure, the Project Company may direct the Contractor to reinstate the works or change the works. The cost of the reinstatement work or any change to the works arising from a direction by the Project Company under this clause will be dealt with as a variation except to the extent that the loss or damage has been caused or exacerbated by the failure of the Contractor to fulfil its obligations under this contract. [ ].4 Except as contemplated in clause [ ].3, the cost of all reinstatement works will be borne by the Contractor. This clause is useful because it enables the Project Company to, at its option, have the damaged section of the project rebuilt as a variation to the existing EPC Contract. This will usually be cheaper than recontracting for construction of the damaged sections of the works. Sample risk register and action plan PwC 132 Operation and maintenance Operating and maintenance manuals The Contractor is usually required to prepare a detailed operating and maintenance manual (O&M Manual). The EPC Contract should require the Contractor to prepare a draft of the O&M Manual within a reasonable time to enable the Project Company, the Operator and possibly the Lenders to provide comments, which can be incorporated into a final draft at least six months before the start of commissioning. The draft should include all information which may be required for start-up, all modes of operation during normal and emergency conditions and maintenance of all systems of the facility. Operating and maintenance personnel It is common for the Contractor to partake in the training of the operations and maintenance staff supplied by the Project Company. The cost of this training will be built into the contract price. It is important to ensure the training is sufficient to enable such staff to be able to efficiently, prudently, safely and professionally operate the facility upon commercial operation. Therefore, the framework for the training should be described in the Appendix dealing with the scope of work (in as much detail as possible). This should include the standards of training and the timing for training. The Project Company’s personnel trained by the Contractor will also usually assist in the commissioning and testing of the facility. They will do this under the direction and supervision of the Contractor. Therefore, absent specific drafting to the contrary, if problems arise during commissioning and/or testing the Contractor can argue they are entitled to an extension of time etc. We recommend inserting the following clause: [ ].1 The Project Company must provide a sufficient number of competent and qualified operating and maintenance personnel to assist the Contractor to properly carry out commissioning and the commercial operation performance tests. [ ].2 Prior to the date of commercial operation, any act or omission of any personnel provided by the Project Company pursuant to GC [ ].1 is, provided those personnel are acting in accordance with the Contractor’s instructions, directions, procedures or manuals, deemed to be an act or omission of the Contractor and the Contractor is not relieved of its obligations under this contract or have any claim against the Project Company by reason of any act or omission. Spare parts The Contractor is usually required to provide, as part of its scope of works, a full complement of spare parts (usually specified in the appendices (the scope of work or the specification)) to be available at the commencement of commercial operation. Further, the Contractor should be required to replace any spare parts used in rectifying defects during the defects liability period, at its sole cost. There should also be a time limit imposed on when these spare parts must be back in the store. It is normally unreasonable to require the spare parts to have been replaced by the expiry of the defects liability period because that may, for some long lead time items, lead to an extension of the defects liability period. The Project Company also may wish to have the option to purchase spares parts from the Contractor on favourable terms and conditions (including price) during the remainder of the concession period. In that case it would be prudent to include a term which deals with the situation where the Contractor is unable to continue to manufacture or procure the necessary spare parts. This provision should cover the following points:  written notification from the Contractor to the Project Company of the relevant facts, with sufficient time to enable the Project Company to order a final batch of spare parts from the Contractor  the Contractor should deliver to, or procure for the Project Company (at no charge to the Project Company), all drawings, patterns and other technical information relating to the spare parts EPC Contracts in the oil and gas sector PwC 133  the Contractor must sell to the Project Company (at the Project Company’s request) at cost price (less a reasonable allowance for depreciation) all tools, equipment and moulds used in manufacturing the spare parts, to the extent they are available to the Contractor provided it has used its reasonable endeavours to procure them. The Contractor should warrant that the spare parts are fit for their intended purpose and that they are of merchantable quality. At worst, this warranty should expire on the later of:  the manufacturer’s warranty period on the applicable spare part  the expiry of the defects liability period. Dispute Resolution Dispute resolution provisions for EPC Contracts could fill another entire paper. There are numerous approaches that can be adopted depending on the nature and location of the project and the particular preferences of the parties involved. However, there are some general principles which should be adopted. They include:  having a staged dispute resolution process that provides for internal discussions and meetings aimed at resolving the dispute prior to commencing action (either litigation or arbitration)  obliging the Contractor to continue to execute the works pending resolution of the dispute  not permitting commencement of litigation or arbitration, as the case may be, until after commercial operation of the facility. This provision must make provision for the parties to seek urgent interlocutory relief ie injunctions and to commence proceedings prior to the expiry of any limitations period. If the provision does not include these exceptions it risks being unenforceable  providing for consolidation of any dispute with other disputes which arise out of or in relation to the construction of the facility. The power to consolidate should be at the Project Company’s discretion. PwC 134 Appendix 1 Example clause: part 1 – Performance testing and guarantee regime 1 Commissioning tests and mechanical completion 1.1 After the Contractor has provided the Owner’s representative with the marked up as-built contract documents [defined in the contract] the Contractor must carry out the commissioning tests for the relevant system. 1.2 The commissioning tests: (a) for each system must: (i) be performed on a system-by-system basis (ii) include the inspection and checking of equipment and supporting subsystems, trial operation of supporting equipment, initial operation of the system, operation of the system to obtain data, perform system calibration and corrective works and shutdown inspection and correction of defects and non-conforming works identified during the commissioning tests (b) must demonstrate: (i) the capability of major sections of the works to operate in all modes of start-up, steady state, transients, plant changeovers, shutdowns, trips and the like (ii) the technical suitability of the works and its control equipment and the capability of the operational procedures recommended by the Contractor. [Clause 1.2 is optional. The commissioning testing regime can be included in the general testing regime in clause 1.3. The reference to a “system” is a reference to a discrete part of the works that contains several elements but which can be tested independently of the entire works. Examples include the fire safety system, distributed control system and compressors etc.] 1.3 In carrying out any test which requires the Contractor to export product the Contractor must: (a) issue a notice to the Owner’s representative at least 24 hours prior to the time at which it wishes to so supply, detailing the testing or commissioning and including the Contractor’s best estimate of the total period and quantity of product that will be supplied during the test; (b) promptly notify the Owner’s representative if there is any change in the information contained in such notice; and (c) do all things necessary to assist the Owner, including but not limited to cooperating with third parties, so that the Owner can comply with its obligations with respect to the test. Example clause: part 1 – Performance testing and guarantee regime PwC 135 Mechanical completion 1.4 As soon as the facility has, in the opinion of the Contractor, reached the stage of mechanical completion, the Contractor must give notice to the Owner’s representative. 1.5 The Owner’s representative must, promptly, and no later than three days after receipt of the Contractor’s notice under GC 1.4, either issue a facility certificate of mechanical completion in the form specified in Appendix [] stating that the facility has reached mechanical completion or notify the Contractor of any defects and/or deficiencies. 1.6 If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct such defects and/or deficiencies and must repeat the procedure described in GC 1.4. 1.7 If the Owner’s representative is satisfied that the facility has reached mechanical completion, the Owner’s representative must promptly, and no later than three days after receipt of the Contractor’s repeated notice, issue a certificate of mechanical completion stating that the facility has reached mechanical completion as at the date stated in that certificate. 1.8 If the Owner’s representative is not so satisfied, then it must notify the Contractor of any defects and/or deficiencies within three days after receipt of the Contractor’s repeated notice and the above procedure must be repeated. 1.9 If the Owner’s representative fails to issue the certificate of mechanical completion and fails to inform the Contractor of any defects and/or deficiencies within six days after receipt of the Contractor’s notice under GC 1.4 or within three days after receipt of the Contractor’s repeated notice under GC 1.6, then the facility is deemed to have reached mechanical completion as at the date of the Contractor’s notice or repeated notice, as the case may be. 2 Functional tests, emission tests, performance tests and substantial completion Tests 2.1 Upon receipt of the certificate of mechanical completion, or when the facility is deemed to have reached mechanical completion under GC 1.9, the Contractor must carry out the functional tests, emission tests and performance tests, provided the Contractor gives at least 48 hours’ notification to the Owner’s representative prior to commencing such tests. 2.2 The Contractor must not commence any of the functional tests, emission tests or performance tests prior to mechanical completion. 2.3 For the avoidance of doubt, it is a condition precedent to the achievement of substantial completion that the emission tests must be passed. Procedure 2.4 (a) If a functional test, emission test or performance test is interrupted or terminated, for any reason, such test must be restarted from the beginning, unless otherwise approved by the Owner’s representative. (b) The Owner’s representative or the Contractor is entitled to order the cessation of any functional test, emission test or performance test if damage to the works, or other property or personal injury, is likely to result from continuation. (c) If the facility (or part thereof) fails to pass any of the functional tests, emission tests or performance tests (or any repetition thereof in the event of prior failure) or if any functional test, emission test or Example clause: part 1 – Performance testing and guarantee regime PwC 136 performance test is stopped before its completion, such functional test, emission test or performance test must, subject to 48 hours’ prior notice having been given by the Contractor to the Owner’s representative, be repeated as soon as practicable thereafter. All appropriate adjustments and modifications are to be made by the Contractor with all reasonable speed and at its own expense before the repetition of any functional test, emission test or performance test. (d) The results of the functional tests, emission tests and performance tests must be presented in a written report produced by the Contractor and delivered to the Owner’s representative within seven days of the completion of the functional tests, emission tests or performance tests. Such results will be evaluated and approved by the Owner’s representative. In evaluation of such results, no additional allowance will be made for measurement tolerances over and above those specified in the applicable test standard. (e) The report provided in accordance with clause 2.4(d) above shall be in a form agreed by the parties. If no agreement is reached then the report is to be in the form as provided by the Owner’s representative. If the parties fail to agree on a form and the Owner’s representative fails to provide a form of report then the report shall be in a form that complies with best industry practices and contains the information required for the Owner to meet all relevant standards. Substantial completion 2.5 As soon as the facility has, in the opinion of the Contractor, reached the stage of substantial completion, the Contractor must give notice to the Owner’s representative. 2.6 The Owner’s representative must, promptly, and no later than three days after receipt of the Contractor’s notice under GC 2.5, either issue a substantial completion certificate in the form specified in Appendix [ ] stating that the facility has reached substantial completion or notify the Contractor of any defects and/or deficiencies. 2.7 If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct such defects and/or deficiencies and must repeat the procedure described in GC 2.5. 2.8 If the Owner’s representative is satisfied that the facility has reached substantial completion, the Owner must, promptly, and no later than three days after receipt of the Contractor’s repeated notice, issue a substantial completion certificate stating that the facility has reached substantial completion as at the date stated in that certificate. 2.9 If the Owner’s representative is not so satisfied, then it must notify the Contractor of any defects and/or deficiencies within three days after receipt of the Contractor’s repeated notice and the above procedure must be repeated. 2.10 Notwithstanding that all the requirements for the issuing of a substantial completion certificate have not been met, the Owner’s representative may at any time, in its absolute discretion, issue a substantial completion certificate. The issue of a substantial completion certificate in accordance with this GC 2.10 will not operate as an admission that all the requirements of substantial completion have been met, and does not prejudice any of the Owner’s rights, including the right to require the Contractor to satisfy all of the requirements of the contract. 4 Performance guarantees Output performance guarantees 4.1 The Contractor guarantees that, during the same performance tests, the facility and all parts will meet the [describe output guarantees]. Minimum performance guarantees not met 4.2 If, for reasons not attributable to the Owner, either or both of the minimum performance guarantees are not met, the Contractor must, at its cost and expense, make such changes, modifications and/or Example clause: part 1 – Performance testing and guarantee regime PwC 137 additions to the facility or any part as may be necessary so as to meet at least the minimum [describe minimum standard here]. The Contractor must notify the Owner upon completion of the necessary changes, modifications and/or additions and must repeat, subject to the Owner’s rights under GCs 4.3 and 46.2(a)(iii) [termination], the relevant performance tests until the minimum [describe] respectively have been met. Nothing in this GC 4.2 derogates from the Contractor’s obligation to meet the [output guarantees]. 4.3 Notwithstanding this GC 4 or any other provision of this contract, if for reasons not attributable to the Owner at any time after the Contractor has repeated the performance tests the Contractor does not meet either or both minimum performance guarantees, the Owner may require the Contractor to pay: (a) in relation to the minimum performance guarantee(s) that has/have met performance liquidated damages calculated in accordance with section 2.1(a) or section 2.2(a) of Appendix Y; and/or (b) if the minimum [output guarantee] has not been met: (i) an amount equal to the amount the Contractor would have been liable for if the actual rated output of the facility was equal to 95 percent of the [output guarantee] as specified in section 2.1(a) of Appendix Y; and (ii) performance liquidated damages calculated in accordance with section 2.1(b) of Appendix Y; and/or (c) if the minimum [other output guarantee – probably emission] has not been met: (i) an amount equal to the amount the Contractor would have been liable for if the actual net heat rate of the facility was equal to 105 percent of the [other output guarantee] as specified in section 2.2(a) of Appendix Y; and (ii) performance liquidated damages calculated in accordance with section 2.2(b) of Appendix Y. 4.4 The payment of performance liquidated damages under GC 4.3 will be in complete satisfaction of the Contractor’s guarantees under GC 4.1. Minimum performance guarantees met, but not performance guarantees 4.5 Subject to GCs 4.3, 4.6 and 4.7, if, for reasons not attributable to the Owner, both of the [describe the guarantees] are not met but both the minimum performance guarantees are met during the same performance test, the Contractor must, prior to the expiration of the extended testing period: (a) at its cost and expense make such changes, modifications and/or additions to the facility or any part as may be necessary so as to meet the [describe the guarantees] respectively; (b) notify the Owner upon completion of the necessary changes, modifications and/or additions; and (c) repeat the performance tests until the [describe the guarantees] respectively have been met during the same performance test. 4.6 If, during the same performance test, the Contractor has met both the minimum performance guarantees, but not both the [describe the guarantees] by the expiration of the extended testing period, the Contractor must pay the respective performance liquidated damages to the Owner. Example clause: part 1 – Performance testing and guarantee regime PwC 138 4.7 (a) Notwithstanding GC 4.5 and 4.6, the Contractor may at any time during the extended testing period elect to pay performance liquidated damages to the Owner in respect of the failure to meet either or both of the [describe the guarantee] provided the minimum performance guarantees are met. (b) Notwithstanding GCs 4.5 and 4.6, and subject to GC 4.3, the Owner may, provided that the date for commercial operation has passed, require the Contractor to pay performance liquidated damages to the Owner in respect of the failure to meet the [describe the output guarantees]. 4.8 The payment of performance liquidated damages under GC 4.6 or GC 4.7 will be in complete satisfaction of the Contractor’s guarantees under GC 4.1, provided that the facility meets both the minimum [describe the minimum guarantees] as at the date of payment of such performance liquidated damages. Guaranteed availability 4.9 The Contractor guarantees that the facility either in whole or in part will operate at the guaranteed availability for a period of 12 months from not later than two months after the date of commercial operation. 4.10 If at the actual availability period actual output measured is less than the guaranteed availability, the Contractor will pay performance liquidated damages to the Owner as specified in Appendix Y. 4.11 The aggregate liability of the Contractor for performance liquidated damages under GC 4.10 will not exceed the amount calculated in accordance with Appendix [ ]. General 4.12 Performance liquidated damages will be invoiced by the Owner and payment will be due within 21 days of issue of such invoice. At the expiration of 21 days the amount invoiced is a debt due and payable to the Owner on demand and may be deducted from any payments otherwise due from the Owner to the Contractor and the Owner may also have recourse to the security provided under this contract. 4.13 The parties agree that the performance liquidated damages in Appendix Y are a fair and reasonable preestimate of the damages likely to be sustained by the Owner as a result of the Contractor’s failure to meet the performance guarantees. 4.14 The payment of performance liquidated damages under this GC 4 is in addition to any liability of the Contractor for delay liquidated damages under GC [ ]. 4.15 The aggregate liability of the Contractor for delay liquidated damages and performance liquidated damages (provided the Contractor has met both minimum performance guarantees) will not exceed the amount calculated in accordance with section 3 of Appendix Y. The aggregate liability of the Contractor under this GC 4.15 will not apply if the Owner requires the Contractor to pay performance liquidated damages pursuant to GC 4.3. 4.16 If this GC 4 (or any part thereof) is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Owner from claiming performance liquidated damages, the Owner is entitled to claim against the Contractor damages at law for the Contractor’s failure to meet any or all of the performance guarantees. Such damages must not exceed: (a) [set out parameters] 4.17 The Contractor is not entitled to the benefit of the exclusion in GC [ ] [prohibition on claiming consequential loss] in any claim for damages at law by the Owner against the Contractor pursuant to GC 4.16 for the Contractor’s failure to meet any or all of the performance guarantees. PwC 139 Appendix 2 Example clause: part 2 – Extension of time regime [ ].1 The Contractor must immediately give notice to the Project Company of all incidents and/or events of whatsoever nature affecting or likely to affect the progress of the works. [ ].2 Within 15 days after an event has first arisen the Contractor must give a further notice to the Project Company which must include: (a) the material circumstances of the event including the cause or causes; (b) the nature and extent of any delay; (c) the corrective action already undertaken or to be undertaken; (d) the effect on the critical path noted on the programme; (e) the period, if any, by which in its opinion the date for commercial operation should be extended; and (f) a statement that it is a notice pursuant to this GC [ ].2. [ ].3 Where an event has a continuing effect or where the Contractor is unable to determine whether the effect of an event will actually cause delay to the progress of the works so that it is not practicable for the Contractor to give notice in accordance with GC [ ].2, a statement to that effect with reasons together with interim written particulars (including details of the likely consequences of the event on progress of the works and an estimate of the likelihood or likely extent of the delay) must be submitted in place of the notice required under GC [ ].2. The Contractor must then submit to the Project Company, at intervals of 30 days, further interim written particulars until the actual delay caused (if any) is ascertainable, whereupon the Contractor must as soon as practicable but in any event within 30 days give a final notice to the Project Company including the particulars set out in GC [ ].2. [ ].4 The Project Company must, within 30 days of receipt of the notice in GC [ ].2 or the final notice in GC [ ].3 (as the case may be), issue a notice notifying the Contractor’s representative of its determination as to the period, if any, by which the date for commercial operation is to be extended. [ ].5 Subject to the provisions of this GC [ ], the Contractor is entitled to an extension of time to the date for commercial operation as the Project Company assesses, where a delay to the progress of the works is caused by any of the following events, whether occurring before, on or after the date for commercial operation: (g) any act, omission, breach or default by the Project Company, the Project Company’s representative and their agents, employees and Contractors; (h) a variation, except where that variation is caused by an act, omission or default of the Contractor or its sub contractors, agents or employees; (i) a suspension of the works pursuant to GC [ ], except where that suspension is caused by an act, omission or default of the Contractor or its sub contractors, agents or employees; (j) an event of force majeure; or (k) a change of law. [ ].6 Despite any other provisions of this GC [ ], the Project Company may at any time make a fair and reasonable extension of the date for commercial operation. The Project Company has no obligation to Example clause: part 2 – Extension of time regime PwC 140 grant or to consider whether it should grant an extension of time and the Project Company is not required to exercise this discretion for the benefit of the Contractor. [ ].7 The Contractor must constantly use its best endeavours to avoid delay in the progress of the works. [ ].8 If the Contractor fails to submit the notices required under GCs [ ].1, [ ].2 and [ ].3 within the times required then: (a) the Contractor has no entitlement to an extension of time; and (b) the Contractor must comply with the requirements to perform the works by the date for commercial operation. [ ].9 Any principle of law or equity (including those which might otherwise entitle the Contractor to relief and the Prevention Principle) which might otherwise render the date for commercial operation immeasurable and liquidated damages unenforceable will not apply. [ ].10 It is a further condition precedent of the Contractor’s entitlement to an extension of time that the critical path noted on the programme is affected in a manner which might reasonably be expected to result in a delay to the works reaching commercial operation by the date for commercial operation. [ ].11 If there are two or more concurrent causes of delay and at least one of those delays would not entitle the Contractor to an extension of time under this GC [ ] then, to the extent of that concurrency, the Contractor is not entitled to an extension of time. [ ].12 The Project Company may direct the Contractor’s representative to accelerate the works for any reason including as an alternative to granting an extension of time to the date for commercial operation. [ ].13 The Contractor will be entitled to all extra costs necessarily incurred by the Contractor in complying with an acceleration direction under GC [ ].11, except where the direction was issued as a consequence of the failure of the Contractor to fulfil its obligations under this contract. The Project Company must assess and decide as soon as reasonably practical, the extra costs necessarily incurred by the Contractor. PwC 141 6 EPC Contracts in the power sector Introduction Engineering, procurement and construction (EPC) contracts are the most common form of contract used to undertake construction works by the private sector on large-scale and complex infrastructure projects1 . Under an EPC Contract a Contractor is obliged to deliver a complete facility to a DeveloperDeveloper who need only turn a key to start operating the facility, hence EPC Contracts are sometimes called turnkey construction contracts. In addition to delivering a complete facility, the Contractor must deliver that facility for a guaranteed price by a guaranteed date and it must perform to the specified level. Failure to comply with any requirements will usually result in the Contractor incurring monetary liabilities. It is timely to examine EPC Contracts and their use on infrastructure projects given the bad publicity they have received, particularly in contracting circles. A number of Contractors have suffered heavy losses and, as a result, a number of Contractors now refuse to enter into EPC Contracts in certain jurisdictions. This problem has been exacerbated by a substantial tightening in the insurance market. Construction insurance has become more expensive due both to significant losses suffered on many projects and the impact of September 11 on the insurance market. However, because of their flexibility, the value and the certainty Sponsors and Lenders derive from EPC Contracts, and the growing popularity of PFI2 projects, the authors believe EPC Contracts will continue to be the predominant form of construction contract used on large-scale infrastructure projects in most jurisdictions.3 This paper will only focus on the use of EPC Contracts in the power sector. However, the majority of the issues raised are applicable to EPC Contracts used in all sectors. Prior to examining power project EPC Contracts in detail, it is useful to explore the basic features of a power project. 1 By this we mean industry sectors including power, oil and gas, transport, water and telecommunications. 2 The terms private finance initiatives (PFI) and public private partnerships (PPP) are used interchangeably. Sectors which undertake PFI projects include prisons, schools, hospitals, universities and defence. 3 Some jurisdictions, such as the USA, use alternative structures which separate the work into various components. EPC Contracts in the power sector PwC 142 Basic features of a power project The contractual structure The diagram below illustrates the basic contractual structure of a project-financed power project using an EPC contract. The detailed contractual structure will vary from project to project. However, most projects will have the basic structure illustrated above. As can be seen from the diagram, the Project Company4 will usually enter into agreements which cover the following elements:  An agreement which gives the Project Company the right to construct and operate the power station and sell electricity generated by the power station. Traditionally this was a concession agreement (or project agreement) with a relevant government entity granting the Project Company a concession to build and operate the power station for a fixed period of time (usually between 15 and 25 years), after which it was handed back to the government. This is why these projects are sometimes referred to as build operate transfer (BOT) or build own operate transfer (BOOT) projects5 . However, following the deregulation of electricity industries in many countries, merchant power stations are now being constructed. A merchant power project is a project which sells electricity into an electricity market and takes the market price for that electricity. Merchant power projects do not normally require an agreement between the Project Company and a government entity to be constructed. Instead, they need simply to obtain the necessary planning, environmental and building approvals. The nature and extent of these approvals will vary from place to place. In addition, the Project Company will need to obtain the necessary approvals and licences to sell electricity into the market. 4 Given this paper focuses on project-financed infrastructure projects we refer to the Employer as the Project Company. Whilst project companies are usually limited liability companies incorporated in the same jurisdiction as the project is being developed in the actual structure of the Project Company will vary from project to project and jurisdiction to jurisdiction. 5 Power projects undertaken by the private sector and, more particularly, by non-utility companies are also referred to as independent power projects. They are undertaken by independent power producers (IPPs). Government Project Company Lenders EPC Contractor O&M Contractor Fuel Supplier EPC Contract Equity Support Agreement O&M Contract Concession Agreement Financing and Security Agreements PPA/Tolling Agreement Tripartite Agreements Sponsors Offtaker Fuel supply Agreement EPC Contracts in the power sector PwC 143  In traditional project-financed power projects (as opposed to merchant power projects) there is a power purchase agreement (PPA) between the Project Company and the local government authority, where the local government authority undertakes to pay for a set amount of electricity every year of the concession, subject to availability, regardless of whether it actually takes that amount of electricity (referred to as a take or pay obligation). Sometimes a tolling agreement is used instead of a PPA. A tolling agreement is an agreement under which the power purchaser directs how the plant is to be operated and despatched. In addition, the power purchaser is responsible for the provision of fuel. This eliminates one risk variable (for the Project Company) but also limits its operational flexibility. In the absence of a PPA, project companies developing a merchant power plant, and Lenders, do not have the same certainty of cash flow as they would if there was a PPA. Therefore, merchant power projects are generally considered higher risk than non-merchant projects.6 This risk can be mitigated by entering into hedge agreements. Project companies developing merchant power projects often enter into synthetic PPAs or hedge agreements to provide some certainty of revenue. These agreements are financial hedges as opposed to physical sales contracts. Their impact on the EPC Contract is discussed in more detail below.  A construction contract governing the construction of the power station: There are a number of contractual approaches that can be taken to construct a power station. An EPC Contract is one approach. Another option is to have a supply contract, a design agreement and construction contract with or without a project management agreement. The choice of contracting approach will depend on a number of factors including the time available, the Lenders’ requirements and the identity of the Contractor(s). The major advantage of the EPC Contract over the other possible approaches is that it provides for a single point of responsibility. This is discussed in more detail below. Interestingly, on large project-financed projects the Contractor is increasingly becoming one of the Sponsors ie an equity participant in the Project Company. Contractors will ordinarily sell down their interest after financial close because, generally speaking, Contractors will not wish to tie up their capital in operating projects. In addition, once construction is complete the rationale for having the Contractor included in the Ownership consortium no longer exists. Similarly, once construction is complete a project will normally be reviewed as lower risk than a project in construction, therefore, all other things being equal, the Contractor should achieve a good return on its investments. In our experience most projects and almost all large, private sector, power projects use an EPC Contract.  An agreement governing the operation and maintenance of the power station: This is usually a long-term Operating and Maintenance agreement (O&M agreement) with an Operator for the operation and maintenance of the power station. The term of the O&M agreement will vary from project to project. The Operator will usually be a Sponsor especially if one of the Sponsors is an independent power producer (IPP) or utility company whose main business is operating power stations. Therefore, the term of the O&M agreement will likely match the term of the concession agreement. In some financing structures the Lenders will require the Project Company itself to operate the facility. In those circumstances the O&M agreement will be replaced with a technical services agreement under which the Project Company is supplied with the know-how necessary for its own employees to operate the facility.  An agreement governing the supply of fuel to the power station: This is usually a fuel supply agreement, often with the local government authority that regulates the supply of the fuel used to run the power station (eg coal, fuel oil, gas etc.). Obviously, if there is a tolling agreement there is no separate fuel supply agreement. In addition, in some markets and for particular types of projects the Project Company may decide not to enter into a long-term fuel supply agreement but instead elect to purchase fuel in the spot market. This will usually only be feasible for peaking plants and in locations with ample supplies of the necessary fuel. For hydro and wind projects there is also no need for a fuel supply agreement. However, this 6 However, because merchant power projects are generally undertaken in more sophisticated and mature markets there is usually a lower level of country or political risk. Conversely, given the move towards privatisation of electricity markets in various countries, this may no longer be the case. EPC Contracts in the power sector PwC 144 paper focuses on thermal plants. Many of the issues discussed will be applicable to hydro and wind projects, however, those projects have additional risks and issues that need to be taken into account.  Financing and security agreements with the Lenders to finance the development of the project Accordingly, the construction contract is only one of a suite of documents on a power project. Importantly, the Project Company operates the project and earns revenues under contracts other than the construction contract. Therefore, the construction contract must, where practical, be tailored so as to be consistent with the requirements of the other project documents. As a result, it is vital to properly manage the interfaces between the various types of agreements. These interface issues are discussed in more detail later. Bankability A bankable contract is a contract with a risk allocation between the Contractor and the Project Company that satisfies the Lenders. Lenders focus on the ability (or more particularly the lack thereof) of the Contractor to claim additional costs or extensions of time as well as the security provided by the Contractor for its performance. The less comfortable the Lenders are with these provisions the greater amount of equity support the Sponsors will have to provide. In addition, Lenders will have to be satisfied as to the technical risk. Obviously price is also a consideration but that is usually considered separately to the bankability of the contract because the contract price (or more accurately the capital cost of the power station) goes more directly to the bankability of the project as a whole. Before examining the requirements for bankability it is worth briefly considering the appropriate financing structures and lending institutions. The most common form of financing for infrastructure projects is project financing. Project financing is a generic term that refers to financing secured only by the assets of the project itself. Therefore, the revenue generated by the project must be sufficient to support the financing. Project financing is also often referred to as either non-recourse financing or limited recourse financing. The terms non-recourse and limited recourse are often used interchangeably, however, they mean different things. Non-recourse means there is no recourse to the project Sponsors at all and limited recourse means, as the name suggests, there is limited recourse to the Sponsors. The recourse is limited both in terms of when it can occur and how much the Sponsors are forced to contribute. In practice, true non-recourse financing is rare. In most projects the Sponsors will be obliged to contribute additional equity in certain defined situations. Traditionally project financing was provided by commercial Lenders. However, as projects became more complex and financial markets more sophisticated project finance also developed. Whilst commercial Lenders still provide finance, governments now also provide financing either through export credit agencies7 or trans – or multi-national organisations like the World Bank, the Asian Development Bank and European Bank for Reconstruction. In addition, as well as bank borrowings Sponsors are also using more sophisticated products like credit wrapped bonds, securitisation of future cash flows and political risk insurance to provide a portion of the necessary finance. In assessing bankability Lenders will look at a range of factors and assess a contract as a whole. Therefore, in isolation it is difficult to state whether one approach is or is not bankable. However, generally speaking the Lenders will require the following:  a fixed completion date  a fixed completion price  no or limited technology risk  output guarantees 7 Export credit agencies are bodies that provide finance on the condition that the funds are used to purchase equipment manufactured in the country of the export credit agency. EPC Contracts in the power sector PwC 145  liquidated damages for both delay and performance  security from the Contractor and/or its parent  large caps on liability (ideally, there would be no caps on liability, however, given the nature of EPC Contracting and the risks to the Contractors involved there are almost always caps on liability)  restrictions on the ability of the Contractor to claim extensions of time and additional costs. An EPC Contract delivers all of the requirements listed above in one integrated package. This is one of the major reasons why they are the predominant form of construction contract used on large-scale project financed infrastructure projects. Basic features of an EPC Contract The key clauses in any construction contract are those which impact on:  time  cost  quality. The same is true of EPC Contracts. However, EPC Contracts tend to deal with issues with greater sophistication than other types of construction contracts. This is because, as mentioned above, an EPC Contract is designed to satisfy the Lenders’ requirements for bankability. EPC Contracts provide for:  A single point of responsibility: The Contractor is responsible for all design, engineering, procurement, construction, commissioning and testing activities. Therefore, if any problems occur the Project Company need only look to one party – the Contractor – to fix both the problem and provide compensation. As a result, if the Contractor is a consortium comprising several entities the EPC Contract must state that those entities are jointly and severally liable to the Project Company.  A fixed contract price: Risk of cost overruns and the benefit of any cost savings are to the Contractor’s account. The Contractor usually has a limited ability to claim additional money which is limited to circumstances where the Project Company has delayed the Contractor or has ordered variations to the works.  A fixed completion date: EPC Contracts include a guaranteed completion date that is either a fixed date or a fixed period after the commencement of the EPC Contract. If this date is not met the Contractor is liable for delay liquidated damages (DLDs). DLDs are designed to compensate the Project Company for loss and damage suffered as a result of late completion of the power station. To be enforceable in common law jurisdictions, DLDs must be a genuine pre-estimate of the loss or damage that the Project Company will suffer if the power station is not completed by the target completion date. The genuine pre-estimate is determined by reference to the time the contract was entered into. DLDs are usually expressed as a rate per day which represents the estimated extra costs incurred (such as extra insurance, supervision fees and financing charges) and losses suffered (revenue forgone) for each day of delay. In addition, the EPC Contract must provide for the Contractor to be granted an extension of time when it is delayed by the acts or omissions of the Project Company. The extension of time mechanism and reasons why it must be included are discussed later.  Performance guarantees: The Project Company’s revenue will be earned by operating the power station. Therefore, it is vital that the power station performs as required in terms of output, efficiency and reliability. Therefore, EPC Contracts contain performance guarantees backed by performance liquidated damages (PLDs) payable by the Contractor if it fails to meet the performance guarantees. EPC Contracts in the power sector PwC 146 PLDs must also be a genuine pre-estimate of the loss and damage that the Project Company will suffer over the life of the project if the power station does not achieve the specified performance guarantees. As with DLDs, the genuine pre-estimate is determined by reference to the time the contract was signed. PLDs are usually a net present value (NPV) (less expenses) calculation of the revenue forgone over the life of the project. For example, if the output of the plant is five MW less than the specification the PLDs are designed to compensate the Project Company for the revenue forgone over the life of the project by being unable to sell that five MW. PLDs and the performance guarantee regime and its interface with the DLDs and the delay regime are discussed in more detail below.  Caps on liability: As mentioned above most EPC Contractors will not, as a matter of company policy, enter into contracts with unlimited liability. Therefore, EPC Contracts for power projects cap the Contractor’s liability at a percentage of the contract price. This varies from project to project, however, an overall liability cap of 100 percent of the contract price is common. In addition, there are normally sub-caps on the Contractor’s liquidated damages liability. For example, DLDs and PLDs might each be capped at 20 percent of the contract price with an overall cap on both types of liquidated damages of 30 percent of the contract price. There will also likely be a prohibition on the claiming of consequential damages. Put simply consequential damages are those damages which do not flow directly from a breach of contract but which were in the reasonable contemplation of the parties at the time the contract was entered into. This used to mean heads of damage like loss of profit. However, loss of profit is now usually recognised as a direct loss on project-financed projects and, therefore, would be recoverable under a contract containing a standard exclusion of consequential loss clause. Nonetheless, care should be taken to state explicitly that liquidated damages can include elements of consequential damages. Given the rate of liquidated damages is pre-agreed most Contractors will not object to this exception. In relation to both caps on liability and exclusion of liability it is common for there to be some exceptions. The exceptions may apply to either or both the cap on liability and the prohibition on claiming consequential losses. The exceptions themselves are often project specific, however, some common examples include cases of fraud or wilful misconduct, situations where the minimum performance guarantees have not been met and the cap on delay liquidated damages has been reached and breaches of the intellectual property warranties.  Security: It is standard for the Contractor to provide performance security to protect the Project Company if the Contractor does not comply with its obligations under the EPC Contract. The security takes a number of forms including: – A bank guarantee for a percentage, normally in the range of 5–15%, of the contract price. The actual percentage will depend on a number of factors including the other security available to the Project Company, the payment schedule (because the greater the percentage of the contract price unpaid by the Project Company at the time it is most likely to draw on security ie, to satisfy DLD and PLD obligations the smaller the bank guarantee can be), the identity of the Contractor and the risk of it not properly performing its obligations, the price of the bank guarantee and the extent of the technology risk. – Retention ie withholding a percentage (usually 5 –10%) of each payment. Provision is often made to replace retention monies with a bank guarantee (sometimes referred to as a retention guarantee (bond)) – Advance payment guarantee, if an advance payment is made – A parent company guarantee – this is a guarantee from the ultimate parent (or other suitably related entity) of the Contractor which provides that it will perform the Contractor’s obligations if, for whatever reason, the Contractor does not perform.  Variations: The Project Company has the right to order variations and agree to variations suggested by the Contractor. If the Project Company wants the right to omit works either in their entirety or to be able to EPC Contracts in the power sector PwC 147 engage a different Contractor this must be stated specifically. In addition, a properly drafted variations clause should make provision for how the price of a variation is to be determined. In the event the parties do not reach agreement on the price of a variation the Project Company or its representative should be able to determine the price. This determination is subject to the dispute resolution provisions. In addition, the variations clause should detail how the impact, if any, on the performance guarantees is to be treated. For some larger variations the Project Company may also wish to receive additional security. If so, this must also be dealt with in the variations clause.  Defects liability: The Contractor is usually obliged to repair defects that occur in the 12 to 24 months following completion of the performance testing. Defects liability clauses can be tiered. That is the clause can provide for one period for the entire power station and a second, extended period, for more critical items.  Intellectual property: The Contractor warrants that it has rights to all the intellectual property used in the execution of the works and indemnifies the Project Company if any third parties’ intellectual property rights are infringed.  Force majeure: The parties are excused from performing their obligations if a force majeure event occurs. This is discussed in more detail below.  Suspension: The Project Company usually has right to suspend the works.  Termination: This sets out the contractual termination rights of both parties. The Contractor usually has very limited contractual termination rights. These rights are limited to the right to terminate for nonpayment or for prolonged suspension or prolonged force majeure and will be further limited by the tripartite or direct agreement between the Project Company, the Lenders and the Contractor. The Project Company will have more extensive contractual termination rights. They will usually include the ability to terminate immediately for certain major breaches or if the Contractor becomes insolvent and the right to terminate after a cure period for other breaches. In addition, the Project Company may have a right to terminate for convenience. It is likely the Project Company’s ability to exercise its termination rights will also be limited by the terms of the financing agreements.  Performance specification: Unlike a traditional construction contract, an EPC Contract usually contains a performance specification. The performance specification details the performance criteria that the Contractor must meet. However, it does not dictate how they must be met. This is left to the Contractor to determine. A delicate balance must be maintained. The specification must be detailed enough to ensure the Project Company knows what it is contracting to receive but not so detailed that if problems arise the Contractor can argue they are not its responsibility. Whilst there are, as described above, numerous advantages to using an EPC Contract, there are some disadvantages. These include the fact that it can result in a higher contract price than alternative contractual structures. This higher price is a result of a number of factors not least of which is the allocation of almost all the construction risk to the Contractor. This has a number of consequences, one of which is that the Contractor will have to factor into its price the cost of absorbing those risks. This will result in the Contractor building contingencies into the contract price for events that are unforeseeable and/or unlikely to occur. If those contingencies were not included the contract price would be lower. However, the Project Company would bear more of the risk of those unlikely or unforeseeable events. Sponsors have to determine, in the context of their particular project, whether the increased price is worth paying. As a result, Sponsors and their advisers must critically examine the risk allocation on every project. Risk allocation should not be an automatic process. Instead, the Project Company should allocate risk in a sophisticated way that delivers the most efficient result. For example, if a project is being undertaken in an area with unknown geology and without the time to undertake a proper geotechnical survey, the Project Company may be best served by bearing the site condition risk itself as it will mean the Contractor does not have to price a contingency it has no way of quantifying. This approach can lower the risk premium paid by the Project Company. Alternatively, the opposite may be true. The Project Company may wish to pay for the contingency in return for passing off the risk which quantifies and caps its exposure. This type of analysis must be undertaken on all major risks prior to going out to tender. EPC Contracts in the power sector PwC 148 Another consequence of the risk allocation is the fact that there are relatively few construction companies that can and are willing to enter into EPC Contracts. As mentioned in the introduction some bad publicity and a tightening insurance market have further reduced the pool of potential EPC Contractors. The scarcity of EPC Contractors can also result in relatively high contract prices. Another major disadvantage of an EPC Contract becomes evident when problems occur during construction. In return for receiving a guaranteed price and a guaranteed completion date, the Project Company cedes most of the day-to-day control over the construction. Therefore, project companies have limited ability to intervene when problems occur during construction. The more a Project Company interferes the greater the likelihood of the Contractor claiming additional time and costs. In addition, interference by the Project Company will make it substantially easier for Contractors to defeat claims for liquidated damages and defective works. Obviously, ensuring the project is completed satisfactorily is usually more important than protecting the integrity of the contractual structure. However, if a Project Company interferes with the execution of the works they will, in most circumstances, have the worst of both worlds. They will have a contract that exposes them to liability for time and costs incurred as a result of their interference without any corresponding ability to hold the Contractor liable for delays in completion or defective performance. The same problems occur even where the EPC Contract is drafted to give the Project Company the ability to intervene. In many circumstances, regardless of the actual drafting, if the Project Company becomes involved in determining how the Contractor executes the works then the Contractor will be able to argue that it is not liable for either delayed or defective performance. As a result, it is vitally important that great care is taken in selecting the Contractor and in ensuring the Contractor has sufficient knowledge and expertise to execute the works. Given the significant monetary value of EPC Contracts, and the potential adverse consequences if problems occur during construction, the lowest price should not be the only factor used when selecting Contractors. Split EPC Contracts One common variation, particularly in Asia, on the basic EPC structure illustrated above is a split EPC Contract. Under a split EPC Contract, the EPC Contract is, as the name implies, split into two or more separate contracts. The basic split structure (illustrated below) involves splitting the EPC Contract into an onshore construction contract and an offshore supply contract.9 There are two main reasons for using a split contract. The first is because it can result in a lower contract price as it allows the Contractor to make savings in relation to onshore taxes, in particular on indirect and corporate 8 For the purposes of this paper, we have assumed the EPC Contract will be governed by the law of a common law jurisdiction. Where there are differences between jurisdictions we have adopted the English law approach. Therefore, if an EPC Contract is governed by a law other than English law you will need to seek advice from local counsel to ensure the contract is enforceable in the relevant jurisdiction. For further information on liability in EPC Contracts under English law refer to our paper outlined “Position Paper on Liability”. 9 We have prepared a paper that deals with the variations and complications in split EPC Contracts. You should consult that paper, or ask us for a copy, if you want more information on this topic. Guarantor Project Company Offshore Contractor Onshore Contractor Offshore Contract Onshore Contract Wrap-Around Guarantee EPC Contracts in the power sector PwC 149 taxes in the onshore jurisdiction. The second is because it may reduce the cost of complying with local licensing regulations by having more of the works, particularly the design works, undertaken offshore. In addition, in some countries which impose restrictions on who can carry out certain activities like engineering and design services, splitting the EPC Contract can also be advantageous because it can make it easier to repatriate profits. Below is a diagram illustrating a more complex split EPC structure we have used previously that dealt with both tax and licensing issues. Example split EPC Structure Whilst a split EPC Contract can result in costs savings, there are risks to the Project Company in using such a structure. This mainly arises because of the derogation from the principle of single point of responsibility. Unlike a standard EPC Contract, the Project Company cannot look only to a single Contractor to satisfy all the contractual obligations (in particular, design, construction and performance). Under a split structure, there are at least two entities with those obligations. Therefore, a third agreement, a wrap-around guarantee,10 is used to deliver a single point of responsibility despite the split. Under a wrap-around guarantee, an entity, usually either the offshore supplier or the parent company of the contracting entities, guarantees the obligations of both Contractors. This delivers a single point of responsibility to the Project Company and the Lenders. The contracting entities will then enter into a separate agreement to determine how, as between themselves, liability is to be apportioned. However, that agreement is not relevant for the purposes of this paper. 10 This is also called a coordination agreement, an administration agreement or an umbrella deed. Guarantor Onshore Guarantor Project Company B (only onshore entity) Offshore Guarantor Design Agreement Equipment Supply Contract C (an offshore entity) Design Review Contract Construction Contract Project Management Agreement D (an offshore entity) E (an offshore entity) F (an offshore entity) C (an offshore entity) Wrap-Around Guarantee Guarantee AgreementGuarantee Agreement EPC Contracts in the power sector PwC 150 In addition, the wrap-around guarantee will, if properly drafted, prevent the various Contractors from relying on the defaults of the other parties to avoid performing their contractual obligations – a tactic known as a horizontal defence. The wrap-around guarantee should also prevent a Contractor from relying on the Project Company’s default where the Project Company’s default was a result, either directly or indirectly, of the nonperformance, under-performance or delay in performance of any of the other Contractors under their respective contracts. In addition to horizontal defences, the wrap-around guarantee should deal with the following matters:  Guarantees and indemnities: The Guarantor must guarantee the performance of the totality of the works and the ability of the separate parts to work seamlessly  Liquidated damages: This is linked to the issue of horizontal defences discussed above. The wrap-around guarantee must ensure that liquidated damages are paid regardless of which Contractor is late and which Contractor fails to perform. Similarly, the aggregate cap of liability in the wrap-around guarantee must override any caps on liability in the split contracts themselves  Provision of a performance bond by the Guarantor or its parent: It is usually prudent to have the Guarantor provide security for their obligations under the wrap-around guarantee. This may be in addition to or in replacement of the security provided under the EPC Contracts themselves. It will depend on the particular requirements of each project  Liability (and limitation of liability) of the Guarantor: The Guarantor’s liability should be equal to the aggregate liability of the contracting entities under the split EPC Contracts  Duration of the wrap-around guarantee: The wrap-around guarantee should remain in force for as long as possible to offer the Project Company additional protection in the event latent defects occur. In any event, it should remain in force until the expiry of the defects liability period or the resolution of any dispute arising out of or in connection with the construction of the facility, whichever is the later  Dispute resolution: The procedures should be identical to those in the project documents and allow the Project Company to consolidate claims  Termination: Termination of an EPC Contract should automatically terminate the other EPC Contract(s) and the wrap-around guarantee (except in respect of accrued liability)  Tax indemnity: Ideally the Contractor(s) should indemnify the Project Company for any taxes or penalties payable as a result of the split. In addition, the wrap-around guarantee should contain provisions dealing with the practical consequences of splitting the contract and how the contracts and the project should be administered. For example, there should also be clauses dealing with more mundane issues like notices. Notices issued under one contract should be deemed to be notices under the other contracts. Whenever an EPC Contract is split the primary driver both of the general structure of the split and the particular drafting approach must be achieving a tax effective structure. Therefore, tax advice from experts in the relevant jurisdiction must be obtained and those experts must review the split contracts and the wraparound guarantee. EPC Contracts in the power sector PwC 151 Key power specific clauses in power EPC Contracts General interface issues As noted earlier, an EPC Contract is one of a suite of agreements necessary to develop a power project. Therefore, it is vital that the EPC Contract properly interfaces with those other agreements. In particular, care should be taken to ensure the following issues interface properly:  commencement and completion dates  liquidated damages amounts and trigger points  caps on liability  indemnities  entitlements to extensions of time  insurance  force majeure  intellectual property. Obviously, not all these issues will be relevant for all agreements. In addition to these general interface issues that apply to most types of projects, there are also power project issues that must be considered. These issues are mainly concerned with the need to burn fuel and export power. They are discussed in more detail below.11 Those major power-specific interface issues are:  access for the Contractor to the transmission grid to allow timely completion of construction, commissioning and testing (grid access).  consistency of commissioning and testing regimes  fuel specification requirements  interface issues between the relevant government agencies and System Operator and the Contractor. In particular, whilst the Project Company must maintain a long-term or comfortable relationship with either the government or the system Operator the Contractor does not. Grid access Clearly, EPC Contracts will not provide for the handover of the power station to the Project Company and the PPA will not become effective until all commissioning and reliability trialling has been successfully completed. This raises the important issue of the Contractor’s grid access and the need for the EPC Contract to clearly define the obligations of the Project Company in providing grid access. Lenders need to be able to avoid the situation where the Project Company’s obligation to ensure grid access is uncertain. This will result in protracted disputes with the Contractor concerning the Contractor’s ability to place load onto the grid system and to obtain extensions of time in situations where delay has been caused as a result of the failure or otherwise of the Project Company to provide grid access. Grid access issues arise at two differing levels, namely:  the obligation to ensure that the infrastructure is in place  the obligation to ensure that the Contractor is permitted to export power With respect to the obligation to ensure that the infrastructure is in place, the Project Company is the most appropriate party to bear this risk vis-à-vis the Contractor, since the Project Company usually either builds the infrastructure itself or has it provided through the relevant concession agreement. Issues that must be considered include: EPC Contracts in the power sector PwC 152  What are the facilities that are to be constructed and how will these facilities interface with the Contractor’s works? Is the construction of these facilities covered by the PPA, concession agreement or any other construction agreement? If so, are the rights and obligations of the Project Company dealt with in a consistent manner?  What is the timing for completion of the infrastructure – will it fit in with the timing under the EPC Contract? With respect to the Contractor’s ability to export power, the EPC Contract must adequately deal with this risk and satisfactorily answer the following questions to ensure the smooth testing, commissioning and entering of commercial operation:  What is the extent of the grid access obligation? Is it merely an obligation to ensure that the infrastructure necessary for the export of power is in place or does it involve a guarantee that the grid will take all power which the Contractor wishes to produce?  What is the timing for the commencement of this obligation? Does the obligation cease at the relevant target date of completion? If not, does its nature change after the date has passed?  What is the obligation of the Project Company to provide grid access in cases where the Contractor’s commissioning/plant is unreliable – is it merely a reasonableness obligation?  Is the relevant grid robust enough to allow for full testing by the Contractor – for example, the performance of full-load rejection testing?  What is the impact of relevant national grid codes or legislation and their interaction with both the EPC Contract and the PPA? Many EPC Contracts are silent on these matters or raise far more questions than they actually answer. Given that the Project Company’s failure will stem from restrictions imposed on it under either or both the PPA or the concession agreement, the best answer is to back to back the Project Company’s obligations under the EPC Contract (usually to provide an extension of time or costs) with the PPA. This approach will not eliminate the risk associated with grid access issues but will make it more manageable. A variety of projects we have worked on in Asia, particularly in China and the Philippines, have incurred significant amounts of time and costs in determining the grid access obligations under the EPC Contract. This experience has taught us that it is a matter which must be resolved at the contract formation stage. Therefore, we recommend inserting the clauses in part 3 of Appendix 1.12 Interfacing of commissioning and testing regimes It is also important to ensure the commissioning and testing regimes in the EPC Contract mirror the requirements for commercial operation under the PPA. Mismatches only result in delays, lost revenue and liability for damages under the PPA or concession agreement, all of which have the potential to cause disputes. Testing/trialling requirements under both contracts must provide the necessary Project Company satisfaction under the EPC Contract and System Operator/offtaker satisfaction under the PPA. Relevant testing issues which must be considered include:  Are differing tests/trialling required under the EPC Contract and the PPA? If so, are the differences manageable for the Project Company or likely to cause significant disruption?  Is there consistency between obtaining handover from the Contractor under the EPC Contract and commercial operation? It is imperative to prescribe back-to-back testing under the relevant PPA and the EPC Contract which will result in a smoother progress of the testing and commissioning and better facilitate all necessary supervision and certification. It must not be forgotten that various certifications will be required at the Lender level. The last thing the Lenders will want is the process to be held up by their own requirements for certification. To avoid delays and disruption it is important that the Lenders’ engineer is acquainted with the details of the project and, in particular, any potential difficulties with the testing regime. EPC Contracts in the power sector PwC 153 Therefore, any potential problems can be identified early and resolved without impacting on the commercial operation of the power station.  Is the basis of the testing to be undertaken mirrored under both the EPC Contract and the PPA? For example, on what basis are various environmental tests to be undertaken? Are they to be undertaken on a per unit basis or a station output basis?  What measurement methodology is being used? Are the correction factors to be applied under the relevant documents uniform? Are references to international standards or guidelines to a particular edition or version?  Are all tests necessary for the Contractor to complete under the EPC Contract able to be performed as a matter of practice? Significantly, if the relevant specifications are linked to guidelines such as the World Bank environmental guidelines, consideration must be given to changes which may occur in these guidelines. The EPC Contract reflects a snapshot of the standards existing at a time when that contract was signed. It may be a number of years post that date in which the actual construction of the project is undertaken thus allowing for possible mismatches should the legislative/guidelines have changed as regards to environmental concerns. It is important that there is certainty as to which standard applies for both the PPA and the EPC Contract. Is it the standard at the time of entering the EPC Contract or is it the standard which applies at the time of testing? Consideration must therefore be given to the appropriate mechanism to deal with potential mismatches between the ongoing obligation of complying with laws, and the Contractor’s obligation to build to a specification agreed at a previous time. Consideration must be given to requiring satisfaction of guidelines as amended from time to time. The breadth of any change of law provision will be at the forefront of any review. The above issues raise the importance of the testing schedules to the EPC Contract and the PPA. The size and importance of the various projects to be undertaken must mean that the days where schedules are attached at the last minute without being subject to review are gone. Discrepancies between the relevant testing and commissioning requirements will only serve to delay and distract all parties from the successful completion of testing and reliability trials. These are all areas where lawyers can add value to the successful completion of projects by being alert to and dealing with such issues at the contract formation stage. Fuel specification issues The nature of the fuel to be supplied to the Contractor under the EPC Contract is also another important issue. Where there is a tolling agreement, as opposed to a PPA, it is vitally important that an adequate review is done at the EPC Contract level to ensure that the fuel being provided under the tolling agreement meets the requirements of the EPC Contract. Similar consideration will need to be given to any Project Company where there is a PPA structure. Differing fuel specification requirements can only result in delay, cost claims and extension of time claims at the EPC Contract level. Fuel specification issues will be hidden away in the schedules. Again, watch out for those schedules. In addition, where certain tests require specific types or quality of fuel the review should check that there are arrangements in place for that type of quality of fuel to be provided eg high sulphur fuel may be required to properly test the flue gas desulphurisation equipment. EPC Contracts in the power sector PwC 154 Interface issues between the offtaker and the EPC Contractor At a fundamental level, it is imperative that the appropriate party corresponds with the relevant offtaker or System Operator during construction on issues such as the provision of transmission facilities, fuel requirements, testing requirements and timing. The Project Company must ensure the EPC Contract states clearly that it is the appropriate party to correspond with the offtaker and the System Operator. Any uncertainty in the EPC Contract may unfortunately see the EPC Contractor dealing with the offtaker or the System Operator thus possibly risking the relationship of the Project Company with its customer. Significantly, it is the Project Company which must develop and nurture an ongoing and long-term relationship with the offtaker. On the other hand, it is the Contractor’s prime objective to complete the project on time or earlier at a cost which provides it with significant profit. The clash of these conflicting objectives in many cases does not allow for such a smooth process. Again, the resolution of these issues at the EPC Contract formation stage is imperative. Key performance clauses in power EPC Contracts Rationale for imposing liquidated damages Almost every construction contract will impose liquidated damages for delay and impose standards in relation to the quality of construction. Most, however, do not impose PLDs. EPC Contracts impose PLDs because the achievement of the performance guarantees has a significant impact on the ultimate success of a project. Similarly, it is important that the power station commences operation on time because of the impact on the success of the project and because of the liability the Project Company will have under other agreements. This is why DLDs are imposed. DLDs and PLDs are both sticks used to motivate the Contractor to fulfil its contractual obligations. The law of liquidated damages As discussed above, liquidated damages must be a genuine pre-estimate of the Project Company’s loss. If liquidated damages are more than a genuine pre-estimate they will be a penalty and unenforceable. There is no legal sanction for setting a liquidated damages rate below that of a genuine pre-estimate, however, there are the obvious financial consequences. In addition to being unenforceable as a penalty, liquidated damages can also be void for uncertainty or unenforceable because they breach the Prevention Principle. Void for uncertainty means, as the term suggests, that it is not possible to determine how the liquidated damages provisions work. In those circumstances, a court will void the liquidated damages provisions. The Prevention Principle was developed by the courts to prevent Employers, ie project companies, from delaying Contractors and then claiming DLDs. It is discussed in more detail below in the context of extensions of time. Prior to discussing the correct drafting of liquidated damages clauses to ensure they are not void or unenforceable it is worth considering the consequences of an invalid liquidated damages regime. If the EPC Contract contains an exclusive remedies clause the result is simple – the Contractor will have escaped liability unless the contract contains an explicit right to claim damages at law if the liquidated damages regime fails. This is discussed in more detail below. If, however, the EPC Contract does not contain an exclusive remedies clause the non-challenging party should be able to claim at law for damages they have suffered as a result of the challenging party’s non – or defective – performance. What then is the impact of the caps in the now invalidated liquidated damages clauses? Unfortunately, the position is unclear in common law jurisdictions, and a definitive answer cannot be provided based upon the current state of authority. It appears the answer varies depending upon whether the clause is invalidated due to its character as a penalty or because of uncertainty or unenforceability. Our view of the current position is set out below. We note that whilst the legal position is not settled the position presented below does appear logical.  Clause invalidated as a penalty: When liquidated damages are unenforceable because they are a penalty (ie they do not represent a genuine pre-estimate of loss), the liquidated damages or its cap will not act as a cap on damages claims at general law. We note that it is rare for a court to find liquidated damages are penalties in contracts between two sophisticated, well advised parties. EPC Contracts in the power sector PwC 155  Clause invalidated due to acts of prevention by the Principal: Where a liquidated damages clause is invalidated due to an act of prevention by the Principal for which the Contractor is not entitled to an extension of time, the liquidated damages or its cap will not act as a cap on damages claims at general law. A liquidated damages clause which is unworkable or too uncertain to ascertain what the parties intended is severed from the EPC Contract in its entirety and will not act as a cap on the damages recoverable by the Principal from the Contractor. Upon severance, the clause is, for the purposes of contractual interpretation, ignored. However, it should be noted that the threshold test for rendering a clause void for uncertainty is high, and courts are reluctant to hold that the terms of a contract, in particular a commercial contract where performance is well advanced, are uncertain. Drafting of liquidated damages clauses Given the role liquidated damages play in ensuring EPC Contracts are bankable and the consequences detailed above of the regime not being effective, it is vital to ensure they are properly drafted to ensure Contractors cannot avoid their liquidated damages liability on a legal technicality. Therefore, it is important, from a legal perspective, to ensure DLDs and PLDs are dealt with separately. If a combined liquidated damages amount is levied for late completion of the works, it risks being struck out as a penalty because it will overcompensate the Project Company. However, a combined liquidated damages amount levied for underperformance may under-compensate the Project Company. Our experience shows that there is a greater likelihood of delayed completion than there is of permanent underperformance. One of the reasons why projects are not completed on time is Contractors are often faced with remedying performance problems. This means, from a legal perspective, if there is a combination of DLDs and PLDs, the liquidated damages rate should include more of the characteristics of DLDs to protect against the risk of the liquidated damages being found to be a penalty. If a combined liquidated damages amount includes an NPV or performance element the Contractor will be able to argue that the liquidated damages are not a genuine pre-estimate of loss when liquidated damages are levied for late completion only. However, if the combined liquidated damages calculation takes on more of the characteristics of DLDs the Project Company will not be properly compensated if there is permanent underperformance. It is also important to differentiate between the different types of PLDs to protect the Project Company against arguments by the Contractor that the PLDs constitute a penalty. For example, if a single PLDs rate is only focused on output and not efficiency, problems and uncertainties will arise if the output guarantee is met but one or more of the efficiency guarantees are not. In these circumstances, the Contractor will argue that the PLDs constitute a penalty because the loss the Project Company suffers if the efficiency guarantees are not met are usually smaller than if the output guarantees are not met. As a result, power project EPC Contracts normally impose two types of PLDs, one for output (ie how many megawatts the power station produces) and one for heat rate (ie how much fuel the power station burns to generate the required output of electricity). Drafting of the performance guarantee regime Now that it is clear that DLDs and PLDs must be dealt with separately it is worth considering, in more detail, how the performance guarantee regime should operate. A properly drafted performance testing and guarantee regime is important because the success or failure of the project depends, all other things being equal, on the performance of the power station. The major elements of the performance regime are:  testing  guarantees  liquidated damages. EPC Contracts in the power sector PwC 156 Liquidated damages were discussed above. Testing and guarantees are discussed below. Testing Performance tests may cover a range of areas. Three of the most common are:  Functional tests: These test the functionality of certain parts of the power station. For example, pumps, conveyers, pressure vessels etc. They are usually discrete tests which do not test the power station as a whole. Liquidated damages do not normally attach to these tests. Instead, they are absolute obligations that must be complied with. If not, the power station will not reach the next stage of completion (for example, mechanical completion or provisional acceptance).  Emissions tests: These test compliance against environmental requirements. Again, these are normally absolute obligations because the consequences of failure can be as severe as being forced to shut down the power station. These tests should ensure the most stringent obligations imposed on the Project Company, whether by government regulations or by Lenders, are met. Emissions tests occur at various times, including during and after guarantee tests. Liquidated damages are sometimes levied if the Contractor fails the emissions tests. However, given emissions tests are usually related to environmental approvals, it is likely that the power station will not be able to operate if the emissions tests are failed. Therefore, passing the emissions tests is usually an absolute obligation not linked to liquidated damages.  Guarantee tests: These test the ability of the power station to meet the performance criteria specified in the contract. There are often minimum and guaranteed levels of performance specified and, as discussed above, providing the minimum levels are met the consequence of failure is normally the payment of PLDs. Satisfaction of the minimum performance guarantees is normally an absolute obligation. The minimum performance guarantees should be set at a level of performance at which it is economic to accept the power station. Lender’s input will be vital in determining what this level is. However, it must be remembered that Lenders have different interests to the Sponsors. Lenders will, generally speaking, be prepared to accept a power station that provides sufficient income to service the debt. However, in addition to covering the debt service obligations, Sponsors will also want to receive a return on their equity investment. If that will not be provided via the sale of electricity because the Contractor has not met the performance guarantees, the Sponsors will have to rely on the PLDs to earn their return. In some projects, the guarantee tests occur after handover of the power station to the Project Company. This means the Contractor no longer has any liability for DLDs during performance testing. In our view, it is preferable, especially in project-financed projects, for handover to occur after completion of performance testing. This means the Contractor continues to be liable for DLDs until either the power station operates at the guaranteed level or the Contractor pays PLDs where the power station does not operate at the guaranteed level. Obviously, DLDs will be capped (usually at 20 percent of the contract price); therefore, the EPC Contract should give the Project Company the right to call for the payment of the PLDs and accept the power station. If the Project Company does not have this right the problem mentioned above will arise, namely, the Project Company will not have received its power station and will not be receiving any DLDs as compensation. It is common for the Contractor to be given an opportunity to modify the power station if it does not meet the performance guarantees on the first attempt. This is because the PLD amounts are normally very large and most Contractors would prefer to spend the time and the money necessary to remedy performance instead of paying PLDs. Not giving Contractors this opportunity will likely lead to an increased contract price both because Contractors will over-engineer the power station and will build a contingency for paying PLDs into the contract price. The second reason is because in most circumstances the Project Company will prefer to receive a power station that operates at 100 percent capacity. The right to modify and retest is another reason why DLDs should be payable up to the time the performance guarantees are satisfied. If the Contractor is to be given an opportunity to modify and retest the EPC Contract must deal with who bears the costs of the additional fuel and consumables required to undertake the retesting. The cost of the fuel in particular can be significant and should, in normal circumstances, be to the Contractor’s account because the retesting only occurs if the performance guarantees are not met at the first attempt. EPC Contracts in the power sector PwC 157 Technical issues Ideally, the technical testing procedures should be set out in the EPC Contract. However, for a number of reasons, including the fact that it is often not possible to fully scope the testing programme until the detailed design is complete, the testing procedures are usually left to be agreed during construction by the Contractor, the Project Company’s representative or engineer and, if relevant, the Lenders’ engineer. However, a properly drafted EPC Contract should include the guidelines for testing. The complete testing procedures must, as a minimum, set out details of:  Testing methodology: Reference is often made to standard methodologies, for example, the American Society of Mechanical Engineers methodology.  Testing equipment: Who is to provide it, where it is to be located, how sensitive must it be?  Tolerances: What is the margin of error?  Ambient conditions: What atmospheric conditions are assumed to be the base case (testing results will need to be adjusted to take into account any variance from these ambient conditions)? In addition, for power stations with multi-units the testing procedures must state those tests to be carried out on a per unit basis and those on an entire plant basis. Provision of consumables and fuel The responsibility for the provision of consumables and fuel required to carry out the performance tests must be clearly set out in the EPC Contract. In general, the Project Company will be responsible for the provision of both consumables and fuel. As the proper interpretation of the Project Company’s obligation to supply consumables is often a matter of dispute between the Project Company and Contractor, it is important for the EPC Contract to precisely identify the quality and quantity of consumables to be provided as well as the time for provision of those consumables (which should be linked to the progress of the works rather than a specific date). The responsibility for the cost of providing consumables and fuel must also be clearly identified. An example of the performance testing and guarantee regime we have used on a number of projects is included in Appendix 1 to this paper. These example clauses are only extracts from a complete contract and ideally should be read as part of that entire contract and, in particular, with the clauses that deal with DLDs, PLDs, liability, the scope of the Contractor’s obligations, including any fitness for purpose warranties and termination. Nonetheless, they do provide an example of the way a performance testing and liquidated damages regime can operate. The process is best illustrated diagrammatically. Refer to the flowcharts below to see how the various parts of the performance testing regime should interface. EPC Contracts in the power sector PwC 158 Performance guarantees and testing The Plant has or is deemed to have reached Plant Readiness Contractor commences Functional Tests, Emission Tests and Performance Tests Has any of the Functional Tests, Emission Tests or Performance Tests been interrupted or terminated for any reason Particular functional tests, emission tests and performance tests must be restarted Did Owner’s Representative or contractor order cessation of Functional Tests, Emission Tests or Performance Tests due to damage to the Works, other property or personal injury being likely to result from continuation? Has the plant failed to pass any of the functional tests, emission test or performance tests or have any such tests been stopped before its completion? Contractor must repeat particular functional tests. Emission tests and performance tests, subject to 24 hours prior notice from contractor to owner’s representative All appropriate adjustments and modifications to be made by contractor with all reasonable speed and at its own expense prior to repetition of any functional tests, emission tests and performance tests Contractor must produce and present written report of results of the Functional Tests, Emission Tests and Performance Tests within seven days of completion of the Functional Tests, Emission Tests and Performance Tests Owner’s Representative must evaluate and approve results with no allowance for measurement tolerances over and above the ISO test standard Contractor to pay appropriate performance liquidated damages Contractor to pay full Delay Liquidated Damages cap Have the Minimum value Performance Guarantees been met before a reaching the cap on the Delay Liquidated Damages? Has the Owner issued a Substantial Completion Certification even though all of the requirements have not been met? Has the Minimum Rated Output Performance Guarantee and the Minimum Net Heat Rate Performance Guarantee been met during Performance Tests? Has the Rated Output Performance Guarantee and Net Heat Rate Performance Guarantee been met during Performance Tests? Has the Contractor elected to pay Performance Liquidated Damages, before the expiry of the Extended Testing Period? Has the Owner required the Contractor to pay Performance Liquidated Damages before the expiry of the Extended Testing Period? Have the Maximum Performance Guarantees been met before the expiry of the Extended Testing Period? Contractor to pay pro rata Delay Liquidated Damages and Owner to issue Substantial Completion Certificate Contractor pay full Delay Liquidated Damages (cap value) and appropriate performance Liquidated Damages and Owner to issue Substantial Completion Certificate Contractor to pay pro rata Delay Liquidated Damages and appropriate performance Liquidated Damages and Owner to issue Substantial Completion Certificate Completion No Yes Yes Yes No No No No No And Yes Yes No No No Yes Yes Yes Yes Yes EPC Contracts in the power sector PwC 159 Key general clauses in EPC Contracts – Delay and extensions of time The Prevention Principle As noted previously, one of the advantages of an EPC Contract is that it provides the Project Company with a fixed completion date. If the Contractor fails to complete the works by the required date it is liable for DLDs. However, in some circumstances the Contractor is entitled to an extension of the date for completion. Failure to grant an extension for a Project Company-caused delay can void the liquidated damages regime and set time at large. This means the Contractor is only obliged to complete the works within a reasonable time. This is the situation under common law-governed111213 contracts due to the Prevention Principle. The Prevention Principle was developed by the courts to prevent Employers ie project companies from delaying Contractors and then claiming DLDs. The legal basis of the Prevention Principle is unclear and it is uncertain whether you can contract out of the Prevention Principle. Logically, given most commentators believe the Prevention Principle is an equitable principle, explicit words in a contract should be able to override the principle. However, the courts have tended to apply the Prevention Principle even in circumstances where it would not, on the face of it, appear to apply. Therefore, there is a certain amount of risk involved in trying to contract out of the Prevention Principle. The more prudent and common approach is to accept the existence of the Prevention Principle and provide for it in the EPC Contract. The Contractor’s entitlement to an extension of time is not absolute. It is possible to limit the Contractor’s rights and impose preconditions on the ability of the Contractor to claim an extension of time. A relatively standard extension of time (EOT) clause would entitle the Contractor to an EOT for:  an act, omission, breach or default of the Project Company  suspension of the works by the Project Company (except where the suspension is due to an act or omission of the Contractor)  a variation (except where the variation is due to an act or omission of the Contractor)  force majeure Which cause a delay on the critical path14 and about which the Contractor has given notice within the period specified in the contract. It is permissible (and advisable) from the Project Company’s perspective to make both the necessity for the delay to impact the critical path and the obligation to give notice of a claim for an extension of time conditions precedent to the Contractor’s entitlement to receive an EOT. In addition, it is usually good practice to include a general right for the Project Company to grant an EOT at any time. However, this type of provision must be carefully drafted because some judges have held (especially when the Project Company’s representative is an independent third party) the inclusion of this clause imposes a mandatory obligation on the Project Company to grant an extension of time whenever it is fair and reasonable to do so, regardless of the strict contractual requirements. Accordingly, from the Project Company’s perspective it must be made clear that the Project Company has complete and absolute discretion to grant an EOT, and that it is not required to exercise its discretion for the benefit of the Contractor. 11 This discussion assumes the project company will be entering into either a PPA or a tolling agreement. However, some of these issues will also be relevant if the project company is entering into hedging agreements for a merchant project. For example, those hedge agreements will likely mandate a date by which the power station must be capable of commercial operation. Failure to comply with this requirement will incur monetary liability. Similarly there may be availability requirements and certain performance guarantees imposed by the hedge. These requirements must be flowed through to the EPC contract. 12 These clauses will have to be modified to ensure compliance with the relevant regulatory regime. 13 It can arise in civil law countries as well, it will depend on the relevant provisions of the code in those countries. For example, the PRC contract law contains articles that entitle a contractor to an extension of time for employer-caused delays. 14 The critical path is the path on the construction programme that shows the dates when certain activities must be completed by in order to achieve completion by the specified date. EPC Contracts in the power sector PwC 160 Similarly, following some recent common law decisions, the Contractor should warrant that it will comply with the notice provisions that are conditions precedent to its right to be granted an EOT. We recommend using the clause in part 2 of Appendix 1. Concurrent delay You will note that in the suggested EOT clause, one of the subclauses refers to concurrent delays. This is relatively unusual because most EPC Contracts are silent on this issue. For the reasons explained below we do not agree with that approach. A concurrent delay occurs when two or more causes of delay overlap. It is important to note that it is the overlapping of the causes of the delays not the overlapping of the delays themselves. In our experience, this distinction is often not made. This leads to confusion and sometimes disputes. More problematic is when the contract is silent on the issue of concurrent delay and the parties assume the silence operates to their benefit. As a result of conflicting case law it is difficult to determine who, in a particular fact scenario, is correct. This can also lead to protracted disputes and outcomes contrary to the intention of the parties. There are a number of different causes of delay which may overlap with delay caused by the Contractor. The most obvious causes are the acts or omissions of a Project Company. A Project Company often has obligations to provide certain materials or infrastructure to enable the Contractor to complete the works. The timing for the provision of that material or infrastructure (and the consequences for failing to provide it) can be affected by a concurrent delay. For example, the Project Company is usually obliged, as between the Project Company and the Contractor, to provide a transmission line to connect to the power station by the time the Contractor is ready to commission the power station. Given the construction of the transmission line can be expensive, the Project Company is likely to want to incur that expense as close as possible to the date commissioning is due to commence. For this reason, if the Contractor is in delay the Project Company is likely to further delay incurring the expense of building the transmission line. In the absence of a concurrent delay clause, this action by the Project Company, in response to the Contractor’s delay, could entitle the Contractor to an extension of time. Concurrent delay is dealt with differently in the various international standard forms of contract. Accordingly, it is not possible to argue that one approach is definitely right and one is definitely wrong. In fact, the right approach will depend on which side of the table you are sitting. In general, there are three main approaches for dealing with the issue of concurrent delay. These are:  Option one: The Contractor has no entitlement to an extension of time if a concurrent delay occurs.  Option two: The Contractor has an entitlement to an extension of time if a concurrent delay occurs.  Option three: The causes of delay are apportioned between the parties and the Contractor receives an extension of time equal to the apportionment. For example, if the causes of a 10-day delay are apportioned 60:40 Project Company: Contractor, the Contractor would receive a six-day extension of time. Each of these approaches is discussed in more detail below. EPC Contracts in the power sector PwC 161 Option one: Contractor not entitled to an extension of time for concurrent delays A common, Project Company friendly, concurrent delay clause for this option one is: If more than one event causes concurrent delays and the cause of at least one of those events, but not all of them, is a cause of delay which would not entitle the Contractor to an extension of time under [EOT clause], then to the extent of the concurrency, the Contractor will not be entitled to an extension of time. Nothing in the clause prevents the Contractor from claiming an extension of time under the general extension of time clause. What the clause does do is to remove the Contractor’s entitlement to an extension of time when there are two or more causes of delay and at least one of those causes would not entitle the Contractor to an extension of time under the general extension of time clause. For example, if the Contractor’s personnel were on strike and during that strike the Project Company failed to approve drawings, in accordance with the contractual procedures, the Contractor would not be entitled to an extension of time for the delay caused by the Project Company’s failure to approve the drawings. The operation of this clause is best illustrated diagrammatically. Example 1: Contractor not entitled to an extension of time for Project Company-caused delay In this example, the Contractor would not be entitled to any extension of time because the Contractor Delay 2 overlap entirely the Project Company delay. Therefore, using the example clause above, the Contractor is not entitled to an extension of time to the extent of the concurrency. As a result, at the end of the Contractor Delay 2 the Contractor would be in eight weeks’ delay (assuming the Contractor has not, at its own cost and expense accelerated the works). Example 2: Contractor entitled to an extension of time for Project Company-caused delay In this example, where there is no overlap between the Contractor and Project Company delay events the Contractor would be entitled to a two week extension of time for the Project Company delay. Therefore, at the end of the Project Company delay the Contractor will remain in six weeks’ delay, assuming no acceleration. Contractor Delay 1 Contractor Delay 2 6 weeks 2 weeks 2 weeks Project Company Delay Contractor Delay 1 Contractor Delay 2 6 weeks 2 weeks 1 week Project Company Delay EPC Contracts in the power sector PwC 162 Example 3: Contractor entitled to an extension of time for a portion of the Project Companycaused delay In this example, the Contractor would be entitled to a one week extension of time because the delays overlap for one week. Therefore, the Contractor is entitled to an extension of time for the period when they do not overlap ie when the extent of the concurrency is zero. As a result, after receiving the one week extension of time, the Contractor would be in seven weeks’ delay, assuming no acceleration. From a Project Company’s perspective, we believe, this option is both logical and fair. For example, if, in example 2, the Project Company delay was a delay in the approval of drawings and the Contractor delay was the entire workforce being on strike, what logic is there in the Contractor receiving an extension of time? The delay in approving drawings does not actually delay the works because the Contractor could not have used the drawings given its workforce was on strike. In this example, the Contractor would suffer no detriment from not receiving an extension of time. However, if the Contractor did receive an extension of time it would effectively receive a windfall gain. The greater number of obligations the Project Company has, the more reluctant the Contractor will likely be to accept option one. Therefore, it may not be appropriate for all projects. Option two: Contractor entitled to an extension of time for concurrent delays Option two is the opposite of option one and is the position in many of the Contractor friendly standard forms of contract. These contracts also commonly include extension of time provisions to the effect that the Contractor is entitled to an extension of time for any cause beyond its reasonable control which, in effect, means there is no need for a concurrent delay clause. The suitability of this option will obviously depend on which side of the table you are sitting. This option is less common than option one but is nonetheless sometimes adopted. It is especially common when the Contractor has a superior bargaining position. Option three: responsibility for concurrent delays is apportioned between the parties Option three is a middle ground position that has been adopted in some of the standard form contracts. For example, the Australian Standards construction contract AS4000 adopts the apportionment approach. The AS4000 clause states: 34.4 Assessment When both non-qualifying and qualifying causes of delay overlap, the superintendent shall apportion the resulting delay to WUC according to the respective causes’ contribution. In assessing each EOT the Superintendent shall disregard questions of whether:  WUC can nevertheless reach practical completion without an EOT 6 weeks 2 weeks Project Company Delay Event Contractor Delay 1 Delay EPC Contracts in the power sector PwC 163  the Contractor can accelerate, but shall have regard to what prevention and mitigation of the delay has not been effected by the Contractor. We appreciate the intention behind the clause and the desire for both parties to share responsibility for the delays they cause. However, we have some concerns about this clause and the practicality of the apportionment approach in general. It is easiest to demonstrate our concerns with an extreme example. For example, what if the qualifying cause of delay was the Project Company’s inability to provide access to the site and the nonqualifying cause of delay was the Contractor’s inability to commence the works because it had been blackbanned by the unions. How should the causes be apportioned? In this example, the two causes are both 100 percent responsible for the delay. In our view, an example like the above where both parties are at fault has two possible outcomes. Either:  the delay is split down the middle and the Contractor receives 50% of the delay as an extension of time  the delay is apportioned 100% to the Project Company and therefore the Contractor receives 100% of the time claimed. The delay is unlikely to be apportioned 100% to the Contractor because a judge or arbitrator will likely feel that that is unfair, especially if there is a potential for significant liquidated damages liability. We appreciate the above is not particularly rigorous legal reasoning, however, the clause does not lend itself to rigorous analysis. In addition, option three is only likely to be suitable if the party undertaking the apportionment is independent from both the Project Company and the Contractor. Exclusive remedies and fail safe clauses It is common for Contractors to request the inclusion of an exclusive remedies clause in an EPC Contract. However, from the perspective of a Project Company, the danger of an exclusive remedies clause is that it prevents the Project Company from recovering any type of damages not specifically provided for in the EPC contract. An EPC Contract is conclusive evidence of the agreement between the parties to that contract. If a party clearly and unambiguously agrees that their only remedies are those within the EPC Contract, they will be bound by those terms. However, the courts have been reluctant to come to this conclusion without clear evidence of an intention of the parties to the EPC Contract to contract out of their legal rights. This means if the common law right to sue for breach of EPC Contract is to be contractually removed, it must be done by very clear words. Contractor’s perspective The main reason for a Contractor insisting on a Project Company being subject to an exclusive remedies clause is to have certainty about its potential liabilities. The preferred position for a Contractor will be to confine its liabilities to what is specified in the EPC Contract. For example, an agreed rate of liquidated damages for delay and, where relevant, underperformance of the power station. A Contractor will also generally require the amount of liquidated damages to be subject to a cap and for the EPC Contract to include an overall cap on its liability. Project company’s perspective The preferred position for a Project Company is for it not to be subject to an exclusive remedies clause. An exclusive remedies clause limits the Project Company’s right to recover for any failure of the Contractor to fulfil its contractual obligations to those remedies specified in the EPC Contract. For this reason, an exclusive remedies clause is an illogical clause to include in an EPC Contract from the perspective of a Project Company because it means that the Project Company has to draft a remedy or exception for each obligation – this represents an absurd drafting position. For example, take the situation where the EPC Contract does not have any provision for the recovery of damages other than liquidated damages. In this case, if the Contractor has either paid the maximum amount of liquidated damages or delivered the power station in a manner that does not require the payment of liquidated damages (ie it is delivered on time and performs to specification) but subsequent to that delivery the Project Company is found to have a claim, say for defective design which EPC Contracts in the power sector PwC 164 manifests itself after completion, the Project Company will have no entitlement to recover any form of damages as any remedy for latent defects has been excluded. The problem is exacerbated because most claims made by a Project Company will in some way relate to performance of the power station and PLDs were expressed to be the exclusive remedy for any failure of the power station to perform in the required manner. For example, any determination as to whether the power station is fit for purpose will necessarily depend on the level and standard of the performance of the power station. In addition to claims relating to fitness for purpose, a Project Company may also wish to make claims for, amongst other things, breach of contract, breach of warranty or negligence. The most significant risk for a Project Company in an EPC Contract is where there is an exclusive remedies clause and the only remedies for delay and underperformance are liquidated damages. If, for whatever reason, the liquidated damages regimes are held to be invalid, the Project Company would have no recourse against the Contractor as it would be prevented from recovering general damages at law, and the Contractor would escape liability for late delivery and underperformance of the power station. Fail-safe clauses In contracts containing an exclusive remedies clause, the Project Company must ensure all necessary exceptions are expressly included in the EPC Contract. In addition, drafting must be included to allow the Project Company to recover general damages at law for delay and underperformance if the liquidated damages regimes in the EPC Contract are held to be invalid. To protect the position of a Project Company (if liquidated damages are found for any reason to be unenforceable and there is an exclusive remedies clause), we recommend the following clauses be included in the EPC Contract: [ ].1 If clause [delay liquidated damages] is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Project Company from claiming delay liquidated damages, the Project Company is entitled to claim against the Contractor damages at law for the Contractor’s failure to complete the works by the date for practical completion. [ ].2 If [ ].1 applies, the damages claimed by the Project Company must not exceed the amount specified in item [ ] of Appendix [ ] for any one day of delay and in aggregate must not exceed the percentage of the EPC Contract price specified in item [ ] of Appendix [ ]. These clauses (which would also apply to PLDs) mean that if liquidated damages are held to be unenforceable for any reason the Project Company will not be prevented from recovering general damages at law. However, the amount of damages recoverable at law may be limited to the amount of liquidated damages that would have been recoverable by the Project Company under the EPC Contract if the liquidated damages regime had not been held to be invalid (see discussion above). For this reason, the suggested drafting should be commercially acceptable to a Contractor as its liability for delay and underperformance will be the same as originally contemplated by the parties at the time of entering into the EPC Contract. In addition, if the EPC Contract excludes the parties’ rights to claim their consequential or indirect losses, these clauses should be an exception to that exclusion. The rationale being that the rates of liquidated damages are likely to include an element of consequential or indirect losses. Force Majeure What is force majeure? Force majeure clauses are almost always included in EPC Contracts. However, they are rarely given much thought unless and until one or more parties seek to rely on them. Generally, the assumption appears to be that the risk will not affect us or the force majeure clause is a legal necessity and does not impact on our risk allocation under the contract. Both of these assumptions are inherently dangerous, and, particularly in the second case, incorrect. Therefore, especially in the current global environment, it is appropriate to examine their application. Force majeure is a civil law concept that has no real meaning under the common law. However, force majeure clauses are used in contracts because the only similar common law concept – the doctrine of frustration – is of limited application. For that doctrine to apply the performance of a contract must be radically different from what was intended by the parties. In addition, even if the doctrine does apply, the consequences are unlikely to be those contemplated by the parties. An example of how difficult it is to show frustration is that many of the EPC Contracts in the power sector PwC 165 leading cases relate to the abdication of King Edward VIII before his coronation and the impact that had on contracts entered into in anticipation of the coronation ceremony. Given force majeure clauses are creatures of contract their interpretation will be governed by the normal rules of contractual construction. Force majeure provisions will be construed strictly and in the event of any ambiguity the contra proferentem rule will apply. Contra proferentem literally means “against the party putting forward”. In this context, it means that the clause will be interpreted against the interests of the party that drafted and is seeking to rely on it. The parties may contract out of this rule. The rule of ejusdem generis which literally means “of the same class” may also be relevant. In other words, when general wording follows a specific list of events, the general wording will be interpreted in light of the specific list of events. In this context it means that when a broad catch-all phrase, such as “anything beyond the reasonable control of the parties”, follows a list of more specific force majeure events the catch-all phrase will be limited to events analogous to the listed events. Importantly, parties cannot invoke a force majeure clause if they are relying on their own acts or omissions. The underlying test in relation to most force majeure provisions is whether a particular event was within the contemplation of the parties when they made the contract. The event must also have been outside the control of the contracting party. There are generally three essential elements to force majeure:  it can occur with or without human intervention  it cannot have reasonably been foreseen by the parties  it was completely beyond the parties’ control and they could not have prevented its consequences. Given the relative uncertainty surrounding the meaning of force majeure we favour explicitly defining what the parties mean. This takes the matter out of the hands of the courts and gives control back to the parties. Therefore, it is appropriate to consider how force majeure risk should be allocated. Drafting force majeure clauses The appropriate allocation of risk in project agreements is fundamental to negotiations between the Project Company and its Contractors. Risks generally fall into the following categories:  risks within the control of the Project Company  risks within the control of the Contractor  risks outside the control of both parties. The negotiation of the allocation of many of the risks beyond the control of the parties, for example, latent site conditions and change of law, is usually very detailed so that it is clear which risks are borne by the Contractor. The same approach should be adopted in relation to the risks arising from events of force majeure. There are two aspects to the operation of force majeure clauses:  the definition of force majeure events  the operative clause that sets out the effect on the parties’ rights and obligations if a force majeure event occurs. The events which trigger the operative clause must be clearly defined. As noted above, it is in the interests of both parties to ensure that the term force majeure is clearly defined. The preferred approach for a Project Company is to define force majeure events as being any of the events in an exhaustive list set out in the contract. In this manner, both parties are aware of which events are force majeure events and which are not. Clearly, defining force majeure events makes the administration of the contract and, EPC Contracts in the power sector PwC 166 in particular, the mechanism within the contract for dealing with force majeure events simpler and more effective. An example exhaustive definition is: An event of force majeure is an event or circumstance which is beyond the control and without the fault or negligence of the party affected and which by the exercise of reasonable diligence the party affected was unable to prevent provided that event or circumstance is limited to the following: a) Riot, war, invasion, act of foreign enemies, hostilities (whether war be declared or not) acts of terrorism, civil war, rebellion, revolution, insurrection of military or usurped power, requisition or compulsory acquisition by any governmental or competent authority b) Ionising radiation or contamination, radio activity from any nuclear fuel or from any nuclear waste from the combustion of nuclear fuel, radioactive toxic explosive or other hazardous properties of any explosive assembly or nuclear component c) Pressure waves caused by aircraft or other aerial devices travelling at sonic or supersonic speeds d) Earthquakes, flood, fire or other physical natural disaster, but excluding weather conditions regardless of severity e) Strikes at national level or industrial disputes at a national level, or strike or industrial disputes by labour not employed by the affected party, its subContractors or its suppliers and which affect an essential portion of the works but excluding any industrial dispute which is specific to the performance of the works or this contract. An operative clause will act as a shield for the party affected by the event of force majeure so that a party can rely on that clause as a defence to a claim that it has failed to fulfil its obligations under the contract. An operative clause should also specifically deal with the rights and obligations of the parties if a force majeure event occurs and affects the project. This means the parties must consider each of the events it intends to include in the definition of force majeure events and then deal with what the parties will do if one of those events occurs. An example of an operative clause is: [ ].1 Neither party is responsible for any failure to perform its obligations under this contract, if it is prevented or delayed in performing those obligations by an event of force majeure. [ ].2 Where there is an event of force majeure, the party prevented from or delayed in performing its obligations under this contract must immediately notify the other party giving full particulars of the event of force majeure and the reasons for the event of force majeure preventing that party from, or delaying that party in performing its obligations under this contract and that party must use its reasonable efforts to mitigate the effect of the event of force majeure upon its or their performance of the contract and to fulfil its or their obligations under the contract. [ ].3 Upon completion of the event of force majeure the party affected must as soon as reasonably practicable recommence the performance of its obligations under this contract. Where the party affected is the Contractor, the Contractor must provide a revised programme rescheduling the works to minimise the effects of the prevention or delay caused by the event of force majeure. [ ].4 An event of force majeure does not relieve a party from liability for an obligation which arose before the occurrence of that event, nor does that event affect the obligation to pay money in a timely manner which matured prior to the occurrence of that event. [ ].5 The Contractor has no entitlement and the Project Company has no liability for: a) Any costs, losses, expenses, damages or the payment of any part of the contract price during an event for force majeure. EPC Contracts in the power sector PwC 167 b) Any delay costs in any way incurred by the Contractor due to an event for force majeure. In addition to the above clause, it is important to appropriately deal with other issues that will arise if a force majeure event occurs. For example, as noted above, it is common practice for a Contractor to be entitled to an extension of time if a force majeure event impacts on its ability to perform the works. Contractors also often request costs if a force majeure event occurs. In our view, this should be resisted. Force majeure is a neutral risk in that it cannot be controlled by either party. Therefore, the parties should bear their own costs. Another key clause that relates to force majeure type events is the Contractor’s responsibility for care of the works and the obligation to reinstate any damage to the works prior to completion. A common example clause is: [ ].1 The Contractor is responsible for the care of the site and the works from when the Project Company makes the site available to the Contractor until 5.00pm on the date of commercial operation. [ ].2 The Contractor must promptly make good loss from, or damage to, any part of the site and the works while it is responsible for their care. [ ].3 If the loss or damage is caused by an event of force majeure, the Project Company may direct the Contractor to reinstate the works or change the works. The cost of the reinstatement work or any change to the works arising from a direction by the Project Company under this clause will be dealt with as a variation except to the extent that the loss or damage has been caused or exacerbated by the failure of the Contractor to fulfil its obligations under this contract. [ ].4 Except as contemplated in clause [ ].3, the cost of all reinstatement works will be borne by the Contractor. This clause is useful because it enables the Project Company to, at its option, have the damaged section of the project rebuilt as a variation to the existing EPC Contract. This will usually be cheaper than recontracting for construction of the damaged sections of the works. Operation and maintenance Operating and maintenance manuals The Contractor is usually required to prepare a detailed operating and maintenance manual (O&M manual). The EPC Contract should require the Contractor to prepare a draft of the O&M manual within a reasonable time to enable the Project Company, the Operator and possibly the Lenders to provide comments, which can be incorporated into a final draft at least six months before the start of commissioning. The draft should include all information which may be required for start-up, all modes of operation during normal and emergency conditions and maintenance of all systems of the power station. Operating and maintenance personnel It is standard for the Contractor to be obliged to train the operations and maintenance staff supplied by the Project Company. The cost of this training will be built into the contract price. It is important to ensure the training is sufficient to enable such staff to be able to efficiently, prudently, safely and professionally operate the power station upon commercial operation. Therefore, the framework for the training should be described in the Appendix dealing with the scope of work (in as much detail as possible). This should include the standards of training and the timing for training. The Project Company’s personnel trained by the Contractor will also usually assist in the commissioning and testing of the power station. They will do this under the direction and supervision of the Contractor. Therefore, absent specific drafting to the contrary, if problems arise during commissioning and/or testing the Contractor can argue they are entitled to an extension of time etc. We recommend inserting the following clause: EPC Contracts in the power sector PwC 168 [ ].1 The Project Company must provide a sufficient number of competent and qualified operating and maintenance personnel to assist the Contractor to properly carry out commissioning and the commercial operation performance tests. [ ].2 Prior to the date of commercial operation, any act or omission of any personnel provided by the Project Company pursuant to GC [ ].1 is, provided those personnel are acting in accordance with the Contractor’s instructions, directions, procedures or manuals, deemed to be an act or omission of the Contractor and the Contractor is not relieved of its obligations under this contract or have any claim against the Project Company by reason of any act or omission. Spare parts The Contractor is usually required to provide, as part of its scope of works, a full complement of spare parts (usually specified in the appendices (the scope of work or the specification)) to be available as at the commencement of commercial operation. Further, the Contractor should be required to replace any spare parts used in rectifying defects during the defects liability period, at its sole cost. There should also be a time limit imposed on when these spare parts must be back in the store. It is normally unreasonable to require the spare parts to have been replaced by the expiry of the defects liability period because that may, for some long lead time items, lead to an extension of the defects liability period. The Project Company also may wish to have the option to purchase spare parts from the Contractor on favourable terms and conditions (including price) during the remainder of the concession period. In that case it would be prudent to include a term which deals with the situation where the Contractor is unable to continue to manufacture or procure the necessary spare parts. This provision should cover the following points:  written notification from the Contractor to the Project Company of the relevant facts, with sufficient time to enable the Project Company to order a final batch of spare parts from the Contractor  the Contractor should deliver to, or procure for the Project Company (at no charge to the Project Company), all drawings, patterns and other technical information relating to the spare parts  the Contractor must sell to the Project Company (at the Project Company’s request) at cost price (less a reasonable allowance for depreciation) all tools, equipment and moulds used in manufacturing the spare parts, to the extent they are available to the Contractor provided it has used its reasonable endeavours to procure them. The Contractor should warrant that the spare parts are fit for their intended purpose, and that they are of merchantable quality. At worst, this warranty should expire on the later of:  the manufacturer’s warranty period on the applicable spare part  the expiry of the defects liability period. Dispute resolution Dispute resolution provisions for EPC Contracts could fill another entire paper. There are numerous approaches that can be adopted depending on the nature and location of the project and the particular preferences of the parties involved. However, there are some general principles which should be adopted. They include:  having a staged dispute resolution process that provides for internal discussions and meetings aimed at resolving the dispute prior to commencing action (either litigation or arbitration)  obliging the Contractor to continue to execute the works pending resolution of the dispute  not permitting commencement of litigation or arbitration, as the case may be, until after commercial operation of the power station. This provision must make exception for the parties to seek urgent EPC Contracts in the power sector PwC 169 interlocutory relief ie injunctions and to commence proceedings prior to the expiry of any limitations period. If the provision does not include these exceptions it risks being unenforceable  providing for consolidation of any dispute with other disputes which arise out of or in relation to the construction of the power station. The power to consolidate should be at the Project Company’s discretion. We have prepared a paper which details the preferred approach to be taken in respect of dispute resolution regimes in various Asian jurisdictions including the PRC, Philippines, Thailand, Vietnam and Taiwan. You should consult this paper, or ask us for a copy, if you want more information on this topic. PwC 170 Appendix 1 Example clause: part 1 – Performance testing and guarantee regime 1 Commissioning tests and power station readiness 1.1 After the Contractor has provided the Owner’s representative with the marked-up drawings of the piping and instrumentation diagrams, logic diagrams and electrical single-line diagrams and control schematics for them, the Contractor must carry out the commissioning tests for the relevant system. 1.2 The commissioning tests: For each system must: (a) Be performed on a system-by-system basis. (b) Include the inspection and checking of equipment and supporting subsystems, trial operation of supporting equipment, initial operation of the system, operation of the system to obtain data, perform system calibration and corrective works, and shutdown inspection and correction of defects and nonconforming works identified during the commissioning tests. Must demonstrate:  The capability of major sections of the works to operate in all modes of start-up, steady state, transients, plant changeovers, shutdowns, trips and the like.  The technical suitability of the works and its control equipment and the capability of the operational procedures recommended by the Contractor. [Clause 1.2 is optional. The commissioning testing regime can be included in the general testing regime in clause 1.3. The reference to a system is a reference to a discrete part of the works that contains several elements but which can be tested independently of the entire works. Examples include the fire safety system, a coal conveyor and crusher system etc.] 1.3 In carrying out any test which requires the Contractor to supply electricity to the transmission network, the Contractor must: (a) Issue a notice to the Owner’s representative at least 24 hours prior to the time at which it wishes to so supply, detailing the testing or commissioning and including the Contractor’s best estimate of the total period and quantity (in MWh per half-hour) of that supply (b) Promptly notify the Owner’s representative if there is any change in the information contained in such notice. (c) Do all things necessary to assist the Owner (including but not limited to cooperating with the network service provider), so that the Owner can comply with its obligations under the grid code. Example clause: part 1 – Performance testing and guarantee regime PwC 171 Power station readiness 1.4 As soon as the power station has, in the opinion of the Contractor, reached the stage of power station readiness, the Contractor must give notice to the Owner’s representative. 1.5 The Owner’s representative must, promptly, and no later than three days after receipt of the Contractor’s notice under GC 1.4, either issue a power station readiness certificate in the form specified in Appendix X stating that the power station has reached power station readiness or notify the Contractor of any defects and/or deficiencies. 1.6 If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct such defects and/or deficiencies and must repeat the procedure described in GC 1.4. 1.7 If the Owner’s representative is satisfied that the power station has reached power station readiness, the Owner’s representative must promptly, and no later than three days after receipt of the Contractor’s repeated notice, issue a power station readiness certificate stating that the power station has reached power station readiness as at the date stated in that certificate. 1.8 If the Owner’s representative is not so satisfied, then it must notify the Contractor of any defects and/or deficiencies within three days after receipt of the Contractor’s repeated notice and the above procedure must be repeated. 1.9 If the Owner’s representative fails to issue the power station readiness certificate and fails to inform the Contractor of any defects and/or deficiencies within six days after receipt of the Contractor’s notice under GC or within three days after receipt of the Contractor’s repeated notice under GC 1.6, then the power station is deemed to have reached power station readiness as at the date of the Contractor’s notice or repeated notice, as the case may be. 2 Functional tests, emission tests, performance tests and substantial completion Tests 2.1 Upon receipt of the power station readiness certificate, or when the power station is deemed to have reached power station readiness under GC 1.9, the Contractor must carry out the functional tests, emission tests and performance tests, provided the Contractor gives at least 48 hours’ notification to the Owner’s representative prior to commencing such tests. 2.2 The Contractor must not commence any of the functional tests, emission tests or performance tests prior to power station readiness. 2.3 For the avoidance of doubt, it is a condition precedent to the achievement of substantial completion that the emission tests must be passed. Procedure 2.4 (a) If a functional test, emission test or performance test is interrupted or terminated, for any reason, such test must be re-started from the beginning, unless otherwise approved by the Owner’s representative. (b) The Owner’s representative or the Contractor is entitled to order the cessation of any functional test, emission test or performance test if damage to the works, or other property or personal injury are likely to result from continuation. (c) If the power station being tested fails to pass any of the functional tests, emission tests or performance tests (or any repetition thereof in the event of prior failure) or if any functional test, emission test or Example clause: part 1 – Performance testing and guarantee regime PwC 172 performance test is stopped before its completion, such functional test, emission test or performance test must, subject to 48 hours’ prior notice having been given by the Contractor to the Owner’s representative, be repeated as soon as practicable thereafter. All appropriate adjustments and modifications are to be made by the Contractor with all reasonable speed and at its own expense before the repetition of any functional test, emission test or performance test. (d) The results of the functional tests, emission tests and performance tests must be presented in a written report produced by the Contractor and delivered to the Owner’s representative within seven days of the completion of the functional tests, emission tests or performance tests. Such results will be evaluated and approved by the Owner’s representative. In evaluation of such results, no additional allowance will be made for measurement tolerances over and above those specified in the applicable ISO test standard. Substantial completion 2.5 As soon as the power station has, in the opinion of the Contractor, reached the stage of substantial completion, the Contractor must give notice to the Owner’s representative. 2.6 The Owner’s representative must, promptly, and no later than three days after receipt of the Contractor’s notice under GC 2.5, either issue a substantial completion certificate in the form specified in Appendix 13 stating that the power station has reached substantial completion or notify the Contractor of any defects and/or deficiencies. 2.7 If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct such defects and/or deficiencies and must repeat the procedure described in GC 2.5. 2.8 If the Owner’s representative is satisfied that the power station has reached substantial completion, the Owner must, promptly, and no later than three days after receipt of the Contractor’s repeated notice, issue a substantial completion certificate stating that the power station has reached substantial completion as at the date stated in that certificate. 2.9 If the Owner’s representative is not so satisfied, then it must notify the Contractor of any defects and/or deficiencies within three days after receipt of the Contractor’s repeated notice and the above procedure must be repeated. 2.10 Notwithstanding that all the requirements for the issuing of a substantial completion certificate have not been met, the Owner’s representative may at any time, in its absolute discretion, issue a substantial completion certificate. The issue of a substantial completion certificate in accordance with this GC 2.10 will not operate as an admission that all the requirements of substantial completion have been met, and does not prejudice any of the Owner’s rights, including the right to require the Contractor to satisfy all these requirements. 3 Reliability test and commercial operation Reliability test 3.1 Upon receipt of the substantial completion certificate the Contractor must carry out the reliability test. 3.2 It is a condition precedent to the commencement of the reliability test that the substantial completion certificate has been issued. 3.3 If the reliability test is interrupted or terminated by the Owner or the Owner’s representative, other than for reason of default by the Contractor, such test must be restarted from the point of interruption or termination. In the case of default by the Contractor, it must be restarted from the beginning or otherwise in accordance with Appendix 1. If the actual rated output specified in the substantial completion certificate is less than the rated output performance guarantee the guaranteed availability in MWh will be recalculated. Example clause: part 1 – Performance testing and guarantee regime PwC 173 Commercial operation 3.4 As soon as the power station has, in the opinion of the Contractor, reached the stage of commercial operation, the Contractor must give notice to the Owner’s representative. 3.5 The Owner’s representative must, promptly, and no later than three days after receipt of the Contractor’s notice under GC 3.4, either issue a commercial operation certificate in the form specified in Appendix 14 stating that the power station has reached commercial operation or notify the Contractor of any defects and/or deficiencies. 3.6 If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct such defects and/or deficiencies and must repeat the procedure described in GC 3.4. 3.7 If the Owner’s representative is satisfied that the power station has reached commercial operation, the Owner must, promptly, and no later than three days after receipt of the Contractor’s repeated notice, issue a commercial operation certificate stating that the power station has reached commercial operation as at the date stated in that certificate. 3.8 If the Owner’s representative is not so satisfied, then it must notify the Contractor of any defects and/or deficiencies within three days after receipt of the Contractor’s repeated notice and the above procedure must repeated. 4 Performance guarantees Net heat rate and rated output performance guarantees 4.1 The Contractor guarantees that, during the same performance tests, the power station and all parts will meet the rated output performance guarantee and the net heat rate performance guarantee. Minimum performance guarantees not met 4.2 If, for reasons not attributable to the Owner, either or both of the minimum performance guarantees are not met, the Contractor must at its cost and expense make such changes, modifications and/or additions to the power station or any part as may be necessary so as to meet at least the minimum rated output performance guarantee and the minimum net heat rate performance guarantee respectively. The Contractor must notify the Owner upon completion of the necessary changes, modifications and/or additions and must repeat, subject to the Owner’s rights under GCs 4.3 and 46.2(a)(iii) [Termination], the relevant performance tests until the minimum rated output performance guarantee and the minimum net heat rate performance guarantee respectively have been met. Nothing in this GC 4.2 derogates from the Contractor’s obligation to meet the rated output performance guarantee and the net heat rate performance guarantee. 4.3 Notwithstanding this GC 4 or any other provision of this contract, if for reasons not attributable to the Owner at any time after the Contractor has repeated the performance tests the Contractor does not meet either or both minimum performance guarantees, the Owner may require the Contractor to pay (a) In relation to the minimum performance guarantee(s) that has/have been met performance liquidated damages calculated in accordance with section 2.1(a) or section 2.2(a) of Appendix Y. (b) If the minimum rated output performance guarantee has not been met: (i) An amount equal to the amount the Contractor would have been liable for if the actual rated output of the power station was equal to 95 percent of the rated output performance guarantee as specified in section 2.1(a) of Appendix Y. (ii) Performance liquidated damages calculated in accordance with section 2.1(b) of Appendix Y. (c) If the minimum net heat rate performance guarantee has not been met: Example clause: part 1 – Performance testing and guarantee regime PwC 174 (i) An amount equal to the amount the Contractor would have been liable for if the actual net heat rate of the power station was equal to 105 percent of the net heat rate performance guarantee as specified in section 2.2(a) of Appendix Y. (ii) Performance liquidated damages calculated in accordance with section 2.2(b) of Appendix Y. 4.4 The payment of performance liquidated damages under GC 4.3 will be in complete satisfaction of the Contractor’s guarantees under GC 4.1. Minimum performance guarantees met, but not performance guarantees 4.5 Subject to GC 4.3, 4.6 and 4.7, if, for reasons not attributable to the Owner, both of the rated output performance guarantee and the net heat rate performance guarantee are not met but both the minimum performance guarantees are met during the same performance test, the Contractor must, prior to the expiration of the extended testing period: (a) At its cost and expense make such changes, modifications and/or additions to the power station or any part as may be necessary so as to meet the rated output performance guarantee and the net heat rate performance guarantee respectively. (b) Notify the Owner upon completion of the necessary changes, modifications and/or additions. (c) Repeat the performance tests until the rated output performance guarantee and the net heat rate performance guarantee respectively have been met during the same performance test. 4.6 If, during the same performance test, the Contractor has met both the minimum performance guarantees, but not both the net heat rate performance guarantee and the rated output performance guarantee by the expiration of the extended testing period, the Contractor must pay the respective performance liquidated damages to the Owner. 4.7 (a) Notwithstanding GC 4.5 and 4.6, the Contractor may at any time during the extended testing period elect to pay performance liquidated damages to the Owner in respect of the failure to meet either or both of the net heat rate performance guarantee and the rated output performance guarantee provided the minimum performance guarantees are met. (b) Notwithstanding GCs 4.5 and 4.6, and subject to GC 4.3, the Owner may, provided that the date for commercial operation has passed, require the Contractor to pay performance liquidated damages to the Owner in respect of the failure to meet either or both of the net heat rate performance guarantee and the rated output performance guarantee. 4.8 The payment of performance liquidated damages under GC 4.6 or GC 4.7 will be in complete satisfaction of the Contractor’s guarantees under GC 4.1, provided that the power station meets both the minimum rated output performance guarantee and the minimum net heat rate performance guarantee as at the date of payment of such performance liquidated damages. Guaranteed availability 4.9 The Contractor guarantees that the power station either in whole or in part will operate at the guaranteed availability for a period of 12 months from not later than two months after the date of commercial operation. 4.10 If during the actual availability period actual energy measured is less than the guaranteed availability, the Contractor will pay performance liquidated damages to the Owner as specified in Appendix Y. 4.11 The aggregate liability of the Contractor for performance liquidated damages under GC 4.10 will not exceed the amount calculated in accordance with Appendix 15. Example clause: part 1 – Performance testing and guarantee regime PwC 175 General 4.12 Performance liquidated damages will be invoiced by the Owner and payment will be due within 21 days of issue of such invoice. At the expiration of 21 days the amount invoiced is a debt due and payable to the Owner on demand and may be deducted from any payments otherwise due from the Owner to the Contractor and the Owner may also have recourse to the security provided under this contract. 4.13 The parties agree that the performance liquidated damages in Appendix Y are a fair and reasonable preestimate of the damages likely to be sustained by the Owner as a result of the Contractor’s failure to meet the performance guarantees. 4.14 The payment of performance liquidated damages under this GC 4 is in addition to any liability of the Contractor for delay liquidated damages under GC [ ]. 4.15 The aggregate liability of the Contractor for delay liquidated damages and performance liquidated damages (provided the Contractor has met both minimum performance guarantees) will not exceed the amount calculated in accordance with section 3 of Appendix Y. The aggregate liability of the Contractor under this GC 4.15 will not apply if the Owner requires the Contractor to pay performance liquidated damages pursuant to GC 4.3. 4.16 If this GC 4 (or any part thereof) is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Owner from claiming performance liquidated damages, the Owner is entitled to claim against the Contractor damages at law for the Contractor’s failure to meet any or all of the performance guarantees. Such damages must not exceed: (a) $[ ] for each megawatt (and pro rata for part of a megawatt) by which the actual output of the power station or part (whichever is applicable) is less than the rated output performance guarantee, unless the actual output of the power station is less than 95 percent of the rated output performance guarantee, in which case such damages will not exceed $[ ] for each megawatt (and pro rata for part of a megawatt) by which the actual output of the power station or part (whichever is applicable) is less than the minimum rated output performance guarantee. (b) $[ ] for each kilojoule/kilowatt hour (and pro rata for part of a kilojoule/kilowatt hour) by which the actual net heat rate of the power station or part (whichever is applicable) exceeds the net heat rate performance guarantee, unless the actual net heat rate of the power station is more than 105 percent of the net heat rate performance guarantee, in which case such damages will not exceed $[ ] for each kilojoule/kilowatt hour (and pro rata for part of a kilojoule/kilowatt hour) by which the actual net heat rate of the power station or part (whichever is applicable) is less than the minimum net heat rate performance guarantee. (c) $[ ] for each megawatt hour (and a proportionate part thereof for each part of a megawatt hour) that the availability period actual energy measured is less than the guaranteed availability. 4.17 The Contractor is not entitled to the benefit of the exclusion in GC [ ] [prohibition on claiming consequential loss] in any claim for damages at law by the Owner against the Contractor pursuant to GC 4.16 for the Contractor’s failure to meet any or all of the performance guarantees. PwC 176 Appendix 2 Example clause: part 2 – Extension of time regime [ ].1 The Contractor must immediately give notice to the Project Company of all incidents and/or events of whatsoever nature affecting or likely to affect the progress of the works. [ ].2 Within 15 days after an event has first arisen the Contractor must give a further notice to the Project Company which must include: (a) The material circumstances of the event including the cause or causes (b) The nature and extent of any delay (c) The corrective action already undertaken or to be undertaken (d) The effect on the critical path noted on the programme (e) The period, if any, by which in its opinion the date for commercial operation should be extended (f) A statement that it is a notice pursuant to this GC [ ].2 [ ].3 Where an event has a continuing effect or where the Contractor is unable to determine whether the effect of an event will actually cause delay to the progress of the works so that it is not practicable for the Contractor to give notice in accordance with GC [ ].2, a statement to that effect with reasons together with interim written particulars (including details of the likely consequences of the event on progress of the works and an estimate of the likelihood or likely extent of the delay) must be submitted in place of the notice required under GC [ ].2. The Contractor must then submit to the Project Company, at intervals of 30 days, further interim written particulars until the actual delay caused (if any) is ascertainable, whereupon the Contractor must as soon as practicable but in any event within 30 days give a final notice to the Project Company including the particulars set out in GC [ ].2. [ ].4 The Project Company must, within 30 days of receipt of the notice in GC [ ].2 or the final notice in GC [ ].3 (as the case may be), issue a notice notifying the Contractor’s representative of its determination as to the period, if any, by which the date for commercial operation is to be extended. [ ].5 Subject to the provisions of this GC [ ], the Contractor is entitled to an extension of time to the date for commercial operation as the Project Company assesses, where a delay to the progress of the works is caused by any of the following events, whether occurring before, on or after the date for commercial operation: (a) Any act, omission, breach or default by the Project Company, the Project Company’s representative and their agents, employees and Contractors (b) A variation, except where that variation is caused by an act, omission or default of the Contractor or its SubContractors, agents or employees (c) A suspension of the works pursuant to GC [ ], except where that suspension is caused by an act, omission or default of the Contractor or its subContractors, agents or employees (d) An event of force majeure (e) A change of law. [ ].6 Despite any other provisions of this GC [ ], the Project Company may at any time make a fair and reasonable extension of the date for commercial operation. Example clause: part 2 – Extension of time regime PwC 177 [ ].7 The Contractor must constantly use its best endeavours to avoid delay in the progress of the works. [ ].8 If the Contractor fails to submit the notices required under GCs [ ].1, [ ].2 and [ ].3 within the times required then: (a) The Contractor has no entitlement to an extension of time (b) The Contractor must comply with the requirements to perform the works by the date for commercial operation (c) Any principle of law or equity (including those which might otherwise entitle the Contractor to relief and the Prevention Principle) which might otherwise render the date for commercial operation immeasurable and liquidated damages unenforceable, will not apply [ ].9 It is a further condition precedent of the Contractor’s entitlement to an extension of time that the critical path noted on the programme is affected in a manner which might reasonably be expected to result in a delay to the works reaching commercial operation by the date for commercial operation. [ ].10 If there are two or more concurrent causes of delay and at least one of those delays would not entitle the Contractor to an extension of time under this GC [ ] then, to the extent of that concurrency, the Contractor is not entitled to an extension of time. [ ].11 The Project Company may direct the Contractor’s representative to accelerate the works for any reason including as an alternative to granting an extension of time to the date for commercial operation. [ ].12 The Contractor will be entitled to all extra costs necessarily incurred, by the Contractor in complying with an acceleration direction under GC [ ].11, except where the direction was issued as a consequence of the failure of the Contractor to fulfil its obligations under this contract. The Project Company must assess and decide as soon as reasonably practical, the extra costs necessarily incurred by the Contractor. PwC 178 Appendix 3 Example clause: part 3 – Grid access regime [ ].1 The Contractor must coordinate the connection of the facility to the transmission line and provide, in a timely manner, suitable termination facilities in accordance with Appendix 1. The Contractor must liaise with the network service provider, government authorities and other parties to avoid delays in connecting the facility to the transmission line. [ ].2 On the date for first synchronisation the Project Company must ensure that there is in place a transmission network which is capable of receiving the generated output the facility is physically capable of producing at any given time. [ ].3 The Project Company’s obligation to ensure that the transmission network is in place is subject to the Contractor being able (physically and legally) to connect the facility to the transmission line and import and/or export power to the transmission network. [ ].4 If the Contractor notifies the Project Company that first synchronisation is likely to take place before the date for first synchronisation, the Project Company must endeavour, but is under no obligation to ensure that the transmission network is in place, to enable first synchronisation to take place in accordance with the Contractor’s revised estimate of first synchronisation. [ ].5 At the time of and following first synchronisation the Project Company will ensure that the Contractor is permitted to export to the transmission network power which the facility is physically capable of exporting, provided that: (a) It is necessary for the Contractor to export that amount of power if the Contractor is to obtain commercial operation (b) The Contractor has complied in all respects with its obligations under GC [ ].7 (c) In the reasonable opinion of the Project Company and/or the network service provider the export of power by the facility will not pose a threat to the safety of persons and/or property (including the transmission network). [ ].6 For the avoidance of doubt, the Project Company will not be in breach of any obligation under this contract by reason only of the Contractor being denied permission to export power to the transmission network in accordance with the grid code. [ ].7 The Contractor must carry out the testing of the works, in particular in relation to the connection of the facility to the transmission network so as to ensure that the Project Company and the Contractor as a Participant (as defined in the electricity code) comply with their obligations under the electricity code in respect of the testing of the works. [ ].8 The Contractor must carry out the testing of the works, in particular in relation to the connection of the facility to the transmission network, so as to ensure that: (a) Any interference to the transmission network is minimised (b) Damage to the transmission network is avoided. [ ].9 The Contractor must promptly report to the Project Company’s representative any interference with and damage to the transmission network which connects with the facility. Example clause: part 3 – Grid access regime PwC 179 [ ].10 Without derogating from the Contractor’s obligations under this contract, in carrying out any test which requires the Contractor to supply electricity to the transmission network, the Contractor must: (a) Issue a notice to the Project Company’s representative at least 24 hours prior to the time at which it wishes to so supply, detailing the testing or commissioning and including the Contractor’s best estimate of the total period and quantity (in MWh per half-hour) of that supply (b) Promptly notify the Project Company’s representative if there is any change in the information contained in such notice (c) Do all things necessary to assist the Project Company (including but not limited to cooperating with the network service provider and complying with its obligations under GC 20.15), so that the Project Company can comply with its obligations under the national electricity code. PwC 180 7 EPC Contracts in the process plant sector Introduction Engineering, Procurement and Construction (EPC) contracts are a common form of contract used to undertake construction works by the private sector on large-scale and complex process plant projects1 . Under an EPC Contract a Contractor is obliged to deliver a complete facility to a Developer who need only turn a key to start operating the facility, hence EPC Contracts are sometimes called turnkey construction contracts. In addition to delivering a complete facility, the Contractor must deliver that facility for a guaranteed price by a guaranteed date and it must perform to the specified level. Failure to comply with any requirements will usually result in the Contractor incurring monetary liabilities. It is timely to examine EPC Contracts and their use on process plant projects given the bad publicity they have received, particularly in contracting circles. A number of Contractors have suffered heavy losses and, as a result, a number of Contractors now refuse to enter into EPC Contracts in certain jurisdictions. This problem has been exacerbated by a substantial tightening in the insurance market. Construction insurance has become more expensive owing both to significant losses suffered on many projects and the impact of September 11 on the insurance market. Further, some project proponents believe that the project delivery methods such as Engineering, Procurement and Construction Management (EPCM) give them greater flexibility and that they have the expertise and experience required to control costs in an EPCM Contract. However, because of their flexibility, the value and the certainty Sponsors and Lenders derive from EPC Contracts, the authors believe EPC Contracts will continue to be a pre-eminent form of construction contract used on large-scale process plant projects in most jurisdictions2 . This paper will only focus on the use of EPC Contracts in the process plant sector. However, the majority of the issues raised are applicable to EPC Contracts used in all sectors. Prior to examining process plant EPC Contracts in detail, it will be useful to explore the basic features of a process plant project. 1 A Liquefied Natural Gas (LNG) project would also usually involve a shipping deal and/or pipeline aspects. 2 Even if the project is developed by a large conglomerate there are usually contracts between the various entities. For example, where the proponent will also be the supplier there will often be a supply agreement put in place so that the new project is properly defeasible and business property accountable. EPC Contracts in the process plant sector PwC 181 Basic features of a process plant project The contractual structure The diagram below illustrates the basic contractual structure of a simple project financed process plant project using an EPC Contract3 . The detailed contractual structure will vary from project to project. However, most projects will have the basic structure illustrated above4 . As can be seen from the diagram, the following agreements will usually be entered into:  A Joint Venture (JV) agreement between the JV participants, which sets out the rights and obligations of the JV participants in relation to management, control and funding of the project. Usually the JV participants will establish a special purpose vehicle (referred to as the Project Company in the above diagram), which will be the entity that will construct and own the process plant facility. There is a significant advantage in establishing a special purpose vehicle as it means that one body is responsible for the delivery of projects, and relationships with government, customers, Contractors and suppliers.  An agreement governing the operation and maintenance of the process plant facility. This is usually a longterm Operating and Maintenance Agreement (O&M agreement) with an Operator for the operation and maintenance of the facility. The term of the O&M agreement will vary from project to project. The Operator will usually be one of the JV participants whose main business is manufacturing the product to be produced at the facility.  A supply agreement governing the supply of feedstock to the process plant. For an ammonia and urea plant or a methanol plant, the main feedstock material is natural gas and therefore the Project Company will usually enter into a gas supply agreement with a local gas supplier. On most projects this will require the construction of infrastructure for the supply of the feedstock to the facility. For example, a pipeline to supply natural gas to the facility. The Project Company will often engage a separate Contractor to design and construct this infrastructure.  Offtake agreements govern the sale of the product of the project. For process plant projects these agreements are crucial to the development proceeding. Financiers will not lend the funds and boards will not approve the project if there are no customers locked in to take the product. The impact of the offtake 3 A LNG project would also usually involve a shipping deal and/or pipeline aspects. 4 Even if the project is developed by a large conglomerate there are usually contracts between the various entities. For example, where the proponent will also be the supplier there will often be a supply agreement put in place so that the new project is properly defeasible and business property accountable Joint Venture Participants Project Company Offtaker Possibly one or more of the JV participants Lenders EPC Contractor O&M Contractor Feedstock Supplier EPC Contract O&M Contract Joint Venture Agreement Financing and Security Agreements Offtake Agreement Tripartite Agreements Feedstock Supply Agreement EPC Contracts in the process plant sector PwC 182 agreement is on practical completion. If there are take or pay agreements it is vital that the project is ready to deliver product from inception date of the offtake agreement or it will face penalties. It may even have to buy product on the open market to meet its obligations. This can be a costly exercise if those markets are thinly traded or demand for these products is high.  Financing and security agreements with the Lenders to finance the development of the project. There are a number of contractual approaches that can be taken to construct a process plant facility. An EPC Contract is one approach. Another option is to have a supply contract, a design agreement and construction contract with or without a project management agreement. The project management can be, and often is, carried out by the proponent itself. Alternatively, an EPCM or project management contract can be used for the management. The choice of contracting approach will depend on a number of factors, including the time available, the Lender’s requirements, the sophistication of the proponent and the identity of the Contractor(s) Accordingly, the construction contract is only one of a suite of documents on a process plant project. Importantly, the promoter or the joint venture participants of the project operate and earn revenue under contracts other than the construction contract. Therefore, the construction contract must, where practical, be tailored so as to be consistent with the requirements of the other project documents. As a result, it is vital to properly manage the interfaces between the various types of agreements. These interface issues are discussed in more detail below. The major advantage of the EPC Contract over the other possible approaches is that it provides for a single point of responsibility. This is discussed in more detail below. Joint venture participants  Interestingly, on large project-financed projects the Contractor is increasingly becoming one of the Sponsors, ie an equity participant in the Project Company. This is not the case in traditional process plant projects. Contractors will ordinarily sell down their interest after financial close because, generally speaking, Contractors will not wish to tie up their capital in operating projects. In addition, once construction is complete the rationale for having the Contractor included in the Ownership consortium often no longer exists. Similarly, once construction is complete a project will normally be reviewed as lower risk than a project in construction, therefore, all other things being equal, the Contractor should achieve a good return on its investments.  Many Developers of process plant companies are large companies that sometimes choose to finance projects from their balance sheet. However, this is not always the case. Often they will seek finance to fund the project or there may be a number of small companies looking to develop assets that are regarded as stranded or too small for large companies to operate profitably. These smaller companies will need finance to carry out these developments. In these cases, the EPC Contractor is required to be a large, experienced participant in the industry that the Sponsors and Lenders are confident can successfully deliver the project and is large enough to cope with losses if it does not. Further, companies with a successful track record means that insurance for the project is easier to obtain. The larger Owners will still use an EPC Contract or design and construct contract for parts of large projects even if self-management, EPCM or project management are used for the greater project. Bankability A bankable contract is a contract with a risk allocation between the Contractor and the Project Company that satisfies the Lenders. Lenders focus on the ability (or more particularly the lack thereof) of the Contractor to claim additional costs and/or extensions of time as well as the security provided by the Contractor for its performance. The less comfortable the Lenders are with these provisions, the greater amount of equity support the Sponsors will have to provide. In addition, Lenders will have to be satisfied as to the technical risk. Obviously price is also a consideration, but that is usually considered separately to the bankability of the contract because the contract price (or more accurately the capital cost of the project facility) goes more directly to the economic bankability of the project as a whole. Before examining the requirements for bankability, it is worth briefly considering the appropriate financing structures and lending institutions. Historically, the most common form of financing for process plant projects is project financing. Project financing is a generic term that refers to financing secured only by the assets of the EPC Contracts in the process plant sector PwC 183 project itself. Therefore, the revenue generated by the project must be sufficient to support the financing. Project financing is also often referred to as either “non-recourse” financing or “limited recourse” financing. The terms “non-recourse” and “limited recourse” are often used interchangeably, however, they mean different things. “Non-recourse” means there is no recourse to the project Sponsor at all and “limited recourse” means, as the name suggests, there is limited recourse to the Sponsor. The recourse is limited both in terms of when it can occur and how much the Sponsor are forced to contribute. In practice, true non-recourse financing is rare. In most projects the Sponsor will be obliged to contribute additional equity in certain defined situations. Traditionally project financing was provided by commercial Lenders. However, as projects became more complex and financial markets more sophisticated, project finance also developed. In addition, as well as bank borrowings Sponsor are also using more sophisticated products like credit wrapped bonds, securitisation of future cash flows and political, technical and completion risk insurance to provide a portion of the necessary finance. In assessing bankability, Lenders will look at a range of factors and assess a contract as a whole. Therefore, in isolation it is difficult to state whether one approach is or is not bankable. However, generally speaking, the Lenders will require the following:  a fixed completion date  a fixed completion price  no or limited technology risk  output guarantees  liquidated damages for both delay and performance  security from the Contractor and/or its parent  large caps on liability (ideally, there would be no caps on liability, however, given the nature of EPC Contracting and the risks to the Contractors involved there are almost always caps on liability)  restrictions on the ability of the Contractor to claim extensions of time and additional costs. An EPC Contract delivers all of the requirements listed above in one integrated package. This is one of the major reasons why they are the predominant form of construction contract used on large-scale project-financed infrastructure projects and why they can be effective on process plant projects. Basic features of an EPC Contract The key clauses in any construction contract are those which impact on:  time  cost  quality. The same is true of EPC Contracts. However, EPC Contracts tend to deal with issues with greater sophistication than other types of construction contracts. This is because, as mentioned above, an EPC Contract is designed to satisfy the Lenders’ requirements for bankability. EPC Contracts provide for:  A single point of responsibility: The Contractor is responsible for all design, engineering, procurement, construction, commissioning and testing activities. Therefore, if any problems occur the Project Company need only look to one party – the Contractor – to both fix the problem and provide compensation. As a EPC Contracts in the process plant sector PwC 184 result, if the Contractor is a consortium comprising several entities the EPC Contract must state that those entities are jointly and severally liable to the Project Company.  A fixed contract price: Risk of cost overruns and the benefit of any cost savings are to the Contractor’s account. The Contractor usually has a limited ability to claim additional money which is limited to circumstances where the Project Company has delayed the Contractor or has ordered variations to the works.  A fixed completion date: EPC Contracts include a guaranteed completion date that is either a fixed date or a fixed period after the commencement of the EPC Contract. If this date is not met the Contractor is liable for delay liquidated damages (DLDs). DLDs are designed to compensate the Project Company for loss and damage suffered as a result of late completion of the facility. To be enforceable in common law jurisdictions,5 DLDs must be a genuine pre-estimate of the loss or damage that the Project Company will suffer if the facility is not completed by the target completion date. The genuine pre-estimate is determined by reference to the time the contract was entered into. DLDs are usually expressed as a rate per day which represents the estimated extra costs incurred (such as extra insurance, supervision fees and financing charges) and losses suffered (revenue forgone) for each day of delay. In addition, the EPC Contract must provide for the Contractor to be granted an extension of time when it is delayed by the acts or omissions of the Project Company. The extension of time mechanism and reasons why it must be included are discussed below.  Performance guarantees: The Project Company’s revenue will be earned by operating the facility. Therefore, it is vital that the facility performs as required in terms of output, efficiency and reliability. Therefore, EPC Contracts contain performance guarantees backed by performance liquidated damages (PLDs) payable by the Contractor if it fails to meet the performance guarantees. The performance guarantees usually comprise a guaranteed production capacity, quality and efficiency. PLDs must also be a genuine pre-estimate of the loss and damage that the Project Company will suffer over the life of the project if the facility does not achieve the specified performance guarantees. As with DLDs, the genuine preestimate is determined by reference to the time the contract was signed. PLDs are usually a net present value (NPV) (less expenses) calculation of the revenue forgone over the life of the project. For example, for an ammonia and urea plant if the production rate of urea is 50 tonnes less than the specification, the PLDs are designed to compensate the Project Company for the revenue forgone over the life of the project by being unable to sell that 50 tonnes of urea. It is possible to have a separate contract that sets out the performance requirements, testing regime and remedies. However, this can create problems where the EPC Contract and the performance guarantees do not match. In our view, the preferred option is to have the performance guarantees in the EPC Contract itself. PLDs and the performance guarantee regime and its interface with the DLDs and the delay regime are discussed in more detail below.  Caps on liability: As mentioned above, most EPC Contractors will not, as a matter of company policy, enter into contracts with unlimited liability. Therefore, EPC Contracts for process plant projects cap the Contractor’s liability at a percentage of the contract price. This varies from project to project, however, a cap of 100% of the contract price is common. In addition, there are normally subcaps on the Contractor’s liquidated damages liability. For example, DLDs and PLDs might each be capped at 20% of the contract price, with an overall cap on both types of liquidated damages of 30% of the contract price. There will also likely be a prohibition on the claiming of consequential damages. Put simply, consequential damages are those damages that do not flow directly from a breach of contract, but which may have been in the reasonable contemplation of the parties at the time the contract was entered into. This used to mean heads of damage like loss of profit. However, loss of profit is now usually recognised as a direct loss on projectfinanced projects and, therefore, would be recoverable under a contract containing a standard exclusion of 5 For the purposes of this paper, we have assumed the EPC Contract will be governed by the law of a common law jurisdiction. Where there are differences between jurisdictions, we have adopted the English law approach. Therefore, if an EPC Contract is governed by a law other than English law you will need to seek advice from local counsel to ensure the contract is enforceable in the relevant jurisdiction. For example, in both the PRC and Malaysia liquidated damages amounts specified in a contract may be subsequently altered by a court. If a party can show that the liquidated damages amounts will either underor in some cases over-compensate a party the court can adjust the damages payable so they more accurately reflect the actual damage suffered by a party. EPC Contracts in the process plant sector PwC 185 consequential loss clause. Nonetheless, care should be taken to state explicitly that liquidated damages can include elements of consequential damages. Given the rate of liquidated damages is pre-agreed, most Contractors will not object to this exception. In relation to both caps on liability and exclusion of liability, it is common for there to be some exceptions. The exceptions may apply to either or both the cap on liability and the prohibition on claiming consequential losses. The exceptions themselves are often project specific, however, some common examples include cases of fraud or wilful misconduct, situations where the minimum performance guarantees have not been met and the cap on delay liquidated damages has been reached, and breaches of the intellectual property warranties.  Security: It is standard for the Contractor to provide performance security to protect the Project Company if the Contractor does not comply with its obligations under the EPC Contract. The security takes a number of forms, including: – A bank guarantee or bond for a percentage, normally in the range of 5–15% of the contract price. The actual percentage will depend on a number of factors including the other security available to the Project Company, the payment schedule (because the greater the percentage of the contract price unpaid by the Project Company at the time it is most likely to draw on security ie to satisfy DLD and PLD obligations the smaller the bank guarantee can be), the identity of the Contractor and the risk of it not properly performing its obligations, the price of the bank guarantee and the extent of the technology risk – Advance payment guarantee, if an advance payment is made – A parent company guarantee – this is a guarantee from the ultimate parent (or other suitable related entity) of the Contractor which provides that it will perform the Contractor’s obligations if, for whatever reason, the Contractor does not perform.  Variations: The Project Company has the right to order variations and agree to variations suggested by the Contractor. If the Project Company wants the right to omit works, either in their entirety or to be able to engage a different Contractor this must be stated specifically. In addition, a properly drafted variations clause should make provision for how the price of a variation is to be determined. In the event the parties do not reach agreement on the price of a variation, the Project Company or its representative should be able to determine the price. This determination is subject to the dispute resolution provisions. In addition, the variations clause should detail how the impact, if any, on the performance guarantees is to be treated. For some larger variations the Project Company may also wish to receive additional security. If so, this must also be dealt with in the variations clause.  Defects liability: The Contractor is usually obliged to repair defects that occur in the 12 to 24 months following completion of the performance testing. Defects liability clauses can be tiered. That is, the clause can provide for one period for the entire facility and a second extended period, for more critical items.  Intellectual property: The Contractor warrants that it has rights to all the intellectual property used in the execution of the works and indemnifies the Project Company if any third parties’ intellectual property rights are infringed.  Force majeure: The parties are excused from performing their obligations if a force majeure event occurs. This is discussed in more detail below.  Suspension: The Project Company usually has a right to suspend the works.  Termination: This sets out the contractual termination rights of both parties. The Contractor usually has very limited contractual termination rights. These rights are limited to the right to terminate for nonpayment or for prolonged suspension or prolonged force majeure and will be further limited by the tripartite or direct agreement between the Project Company, the Lenders and the Contractor. The Project Company will have more extensive contractual termination rights. They will usually include the ability to terminate immediately for certain major breaches or if the Contractor becomes insolvent and the right to terminate after a cure period for other breaches. In addition, the Project Company may have a right to terminate for EPC Contracts in the process plant sector PwC 186 convenience. It is likely the Project Company’s ability to exercise its termination rights will also be limited by the terms of the financing agreements.  Performance specification: Unlike a traditional construction contract, an EPC Contract usually contains a performance specification. The performance specification details the performance criteria that the Contractor must meet. However, it does not dictate how they must be met. This is left to the Contractor to determine. A delicate balance must be maintained. The specification must be detailed enough to ensure the Project Company knows what it is contracting to receive but not so detailed that if problems arise the Contractor can argue they are not its responsibility. Whilst there are, as described above, numerous advantages to using an EPC Contract, there are some disadvantages. These include the fact that it can result in a higher contract price than alternative contractual structures. This higher price is a result of a number of factors, not least of which is the allocation of almost all the construction risk to the Contractor. This has a number of consequences, one of which is that the Contractor will have to factor into its price the cost of absorbing those risks. This will result in the Contractor building contingencies into the contract price for events that are unforeseeable and/or unlikely to occur. If those contingencies were not included, the contract price would be lower. However, the Project Company would bear more of the risk of those unlikely or unforeseeable events. Sponsors have to determine, in the context of their particular project, whether the increased price is worth paying. As a result, Sponsor and their advisors must critically examine the risk allocation on every project. Risk allocation should not be an automatic process. Instead, the Project Company should allocate risk in a sophisticated way that delivers the most efficient result. For example, if a project is being undertaken in an area with unknown geology and without the time to undertake a proper geotechnical survey, the Project Company may be best served by bearing the site condition risk itself as it will mean the Contractor does not have to price a contingency it has no way of quantifying. This approach can lower the risk premium paid by the Project Company. Alternatively, the opposite may be true. The Project Company may wish to pay for the contingency in return for passing off the risk which quantifies and caps its exposure. This type of analysis must be undertaken on all major risks prior to going out to tender. Another consequence of the risk allocation is the fact that there are relatively few engineering and construction companies that can and are willing to enter into EPC Contracts. As mentioned in the introduction, some bad publicity and a tightening insurance market have further reduced the pool of potential EPC Contractors. The scarcity of EPC Contractors can also result in relatively high contract prices. Another major disadvantage of an EPC Contract becomes evident when problems occur during construction. In return for receiving a guaranteed price and a guaranteed completion date, the Project Company cedes most of the day-to-day control over the construction. Therefore, project companies have limited ability to intervene when problems occur during construction. The more a Project Company interferes, the greater the likelihood of the Contractor claiming additional time and costs. In addition, interference by the Project Company will make it substantially easier for Contractors to defeat claims for liquidated damages and defective works. Obviously, ensuring the project is completed satisfactorily is usually more important than protecting the integrity of the contractual structure. However, if a Project Company interferes with the execution of the works they will, in most circumstances, have the worst of both worlds. They will have a contract that exposes them to liability for time and costs incurred as a result of their interference without any corresponding ability to hold the Contractor liable for delays in completion or defective performance. The same problems occur even where the EPC Contract is drafted to give the Project Company the ability to intervene. In many circumstances, regardless of the actual drafting, if the Project Company becomes involved in determining how the Contractor executes the works then the Contractor will be able to argue that it is not liable for either delayed or defective performance. As a result, it is vitally important that great care is taken in selecting the Contractor and in ensuring the Contractor has sufficient knowledge and expertise to execute the works. Given the significant monetary value of EPC Contracts, and the potential adverse consequences if problems occur during construction, the lowest price should not be the only factor used when selecting Contractors. EPC Contracts in the process plant sector PwC 187 Split EPC Contracts One common variation, particularly in Asia, on the basic EPC structure illustrated above is a split EPC Contract. Under a split EPC Contract, the EPC Contract is, as the name implies, split into two or more separate contracts. The basic split structure (illustrated below) involves splitting the EPC Contract into an onshore construction contract and an offshore supply contract.6 There are two main reasons for using a split contract. The first is because it can result in a lower contract price as it allows the Contractor to make savings in relation to onshore taxes; in particular on indirect and corporate taxes in the onshore jurisdiction. The second is because it may reduce the cost of complying with local licensing regulations by having more of the works, particularly the design works, undertaken offshore.7 In addition, in some countries that impose restrictions on who can carry out certain activities like engineering and design services, splitting the EPC Contract can also be advantageous because it can make it easier to repatriate profits. Below is a diagram illustrating a more complex split EPC structure we have used previously that dealt with both tax and licensing issues. 6 We have prepared a paper that deals with the variations and complications in split EPC Contracts. You should consult that paper if you want more information on this topic. 7 Modularisation is now a common form of construction and is an example where a split EPC Contract may be particularly appropriate. Guarantor Project Company Wrap-Around Guarantee Offshore Contract Onshore Contractor Offshore Contractor Onshore Contract EPC Contracts in the process plant sector PwC 188 Example split EPC Structure Example simple split EPC Structure Whilst a split EPC Contract can result in costs savings, there are risks to the Project Company in using such a structure. This mainly arises because of the derogation from the principle of single point of responsibility. Unlike a standard EPC Contract, the Project Company cannot look only to a single Contractor to satisfy all the contractual obligations (in particular, design, construction and performance). Under a split structure, there are at least two entities with those obligations. Therefore, a third agreement, a wrap-around guarantee,8 is used to deliver a single point of responsibility despite the split. Under a wrap-around guarantee, an entity, usually either the offshore supplier or the parent company of the contracting entities, guarantees the obligations of both Contractors. This delivers a single point of responsibility to the Project Company and the Lenders. The contracting entities will then enter into a separate agreement to determine how, as between themselves, liability is to be apportioned. However, that agreement is not relevant for the purposes of this paper. In addition, the wrap-around guarantee will, if properly drafted, prevent the various Contractors from relying on the defaults of the other parties to avoid performing their contractual obligations – a tactic known as a horizontal defence. The wrap-around guarantee should also prevent a Contractor from relying on the Project Company’s default where the Project Company’s default was a result, either directly or indirectly, of the non- 8 This is also called a coordination agreement, an administration agreement or an umbrella deed. Guarantor Offshore Guarantor Project Company B (only onshore entity) Onshore Guarantor Equipment Supply Contract Design Agreement C (an offshore entity) C (an offshore entity) Project Management Agreement Construction Contract Design Review Contract D (an offshore entity) E (an offshore entity) F (an offshore entity) Wrap-Around Guarantee Guarantee Agreement Guarantee Agreement EPC Contracts in the process plant sector PwC 189 performance, under-Guarantor performance or delay in performance of any of the other Contractors under their respective contracts. In addition to horizontal defences, the wrap-around guarantee should deal with the following matters:  Guarantees and indemnities: The Guarantor must guarantee the performance of the totality of the works and the ability of the separate parts to work seamlessly.  Liquidated damages: This is linked to the issue of horizontal defences discussed above. The wrap-around guarantee must ensure that liquidated damages are paid regardless of which Contractor is late and which Contractor fails to perform. Similarly, the aggregate cap of liability in the wrap-around guarantee must override any caps on liability in the split contracts themselves.  Provision of a performance bond by the Guarantor or its parent: It is usually prudent to have the Guarantor provide security for their obligations under the wrap-around guarantee. This may be in addition to or in replacement of the security provided under the EPC Contracts themselves. It will depend on the particular requirements of each project.  Liability (and limitation of liability) of the Guarantor: The Guarantor’s liability should be equal to the aggregate liability of the contracting entities under the split EPC Contracts.  Duration of the wrap-around guarantee: The wrap-around guarantee should remain in force for as long as possible to offer the Project Company additional protection in the event latent defects occur. In any event, it should remain in force until the expiry of the defects liability period or the resolution of any dispute arising out of or in connection with the construction of the facility, whichever is the later.  Dispute resolution: The procedures should be identical to those in the project documents and allow the Project Company to consolidate claims.  Termination: Termination of an EPC Contract should automatically terminate the other EPC Contract(s) and the wrap-around guarantee (except in respect of accrued liability).  Tax indemnity: Ideally the Contractor(s) should indemnify the Project Company for any taxes or penalties payable as a result of the split. In addition, the wrap-around guarantee should contain provisions dealing with the practical consequences of splitting the contract and how the contracts and the project should be administered. For example, there should also be clauses dealing with more mundane issues like notices. Notices issued under one contract should be deemed to be notices under the other contracts. Whenever an EPC Contract is split, the primary driver both of the general structure of the split and the particular drafting approach must be achieving a tax-effective structure. Therefore, tax advice from experts in the relevant jurisdiction must be obtained and those experts must review the split contracts and the wraparound guarantee. EPC Contracts in the process plant sector PwC 190 Key process plant-specific clauses in process plant EPC Contracts General interface issues As noted above, an EPC Contract is one of a suite of agreements necessary to develop a process plant project. Therefore, it is vital that the EPC Contract properly interfaces with those other agreements. In particular, care should be taken to ensure the following issues interface properly:  commencement and completion dates  liquidated damages amounts and trigger points  caps on liability  indemnities  entitlements to extensions of time  insurance  force majeure  intellectual property. Obviously, not all these issues will be relevant for all agreements. In addition to these general interface issues that apply to most types of projects, there are also process plant project issues that must be considered. These issues are many and varied and depend largely on the nature of the project. For example, on a methanol project the facility must be ready and able to accept feedstock, process it to meet rigorous occupational health, safety and environmental guidelines and export methanol to meet supplier and customer demands and contractual obligations. They are discussed in more detail below. Some major process plant-specific interface issues are:  access for the Contractor to the feedstock to allow timely completion of construction, commissioning and testing  consistency of commissioning and testing regimes  feedstock, product and by-product (such as greenhouse emissions) specification requirements  interface issues between the relevant government agencies and System Operator and the Contractor. In particular, whilst the Project Company must maintain a long-term/comfortable relationship with either the government or the system Operator the Contractor does not. Feedstock and product storage Usually, EPC Contracts will not provide for the handover of the facility to the Project Company until all commissioning and reliability trialling has been successfully completed.9 This raises the important issue of the supply of feedstock and other consumables (such as water) and receipt of product during testing and commissioning and the need for the EPC Contract to clearly define the obligations of the Project Company in providing feedstock and sufficient storage or product demand to fully and properly commission and test the facility. 9 Some Owners will, however, carry out the commissioning themselves. EPC Contracts in the process plant sector PwC 191 Lenders need to be able to avoid the situation where the Project Company’s obligation to ensure feedstock and storage (or demand) is uncertain. This will result in protracted disputes with the Contractor concerning the Contractor’s ability to commission and test the facility at design conditions and to obtain extensions of time in situations where delay has been caused as a result of the failure or otherwise of the Project Company to provide sufficient (or sufficient quality) feedstock or storage. With respect to the obligation to ensure the availability of sufficient feedstock, the Project Company is the most appropriate party to bear this risk vis-à-vis the Contractor, since the Project Company usually either builds the infrastructure itself or has it provided through the relevant supply agreement. Issues that must be considered include:  Where is the feedstock from, an existing facility or a new facility?  If it is a new facility, what is the timing for completion of that facility – will it fit in with the timing under the EPC Contract? What are the risks – and what can be done if it is not finished?  Will new infrastructure be required to transport the feedstock material to the site such as the construction of a new pipeline? Will this be completed in time?  What happens if insufficient feedstock is available or not available at all? Contractors will usually want the test to be deemed complete in these circumstances.  What happens if the feedstock does not meet the specification? The EPC Contract should provide an adjustment mechanism to cope with this. From the Project Company’s perspective, the EPC Contract should set out the quantity of feedstock material and the date at which it must be provided. If possible, it should specify a maximum quantity that will be supplied. This will enable the Project Company to arrange the supply of this material by entering into a supply agreement with a third party. With respect to the Contractor’s ability to export product or store product, the EPC Contract must adequately deal with this risk and satisfactorily answer the following questions to ensure the smooth testing, commissioning and achieving commercial operation:  What is the extent of the product export obligation? It will usually be an obligation to provide storage or demand for the product for a fixed period of time.  What is the timing for the commencement of this obligation? Does the obligation cease at the relevant target date of completion? If not, does its nature change after the date has passed?  What is the obligation of the Project Company to provide demand or storage in cases where the Contractor’s commissioning/plant is unreliable – is it merely a reasonableness obligation?  Which party is responsible for loss or damage to the product that is being stored?  What happens if the Project Company fails to provide sufficient storage or demand? Contractors will usually seek to have the test deemed complete. Many EPC Contracts are silent on these matters or raise far more questions than they actually answer. Given that the Project Company’s failure will stem from restrictions imposed on it under its supply or offtake agreements, the best answer is to back-to-back the Project Company’s obligations under the EPC Contract (usually to provide an extension of time and/or costs) with its supply and offtake agreements. This approach will not eliminate the risk associated with commissioning and testing issues, but will make it more manageable. Our experience in a variety of projects has taught us that the issue of availability and quality of feedstock and availability of storage or demand is a matter that must be resolved at the contract formation stage. EPC Contracts in the process plant sector PwC 192 Interfacing of commissioning and testing regimes It is also important to ensure the commissioning and testing regimes in the EPC Contract mirror the requirements of any supply and offtake agreements. Mismatches only result in delays, lost revenue and liability for damages under the EPC Contract, supply or offtake agreements, all of which have the potential to cause disputes. This is even more important where the EPC Contract is part of a larger development, say a methanol plant on the back of a new gas processing plant. For example, the gas process plant might need the methanol plant to take its product as much as the methanol plant needs its product. If the interface is not carefully thought through and agreed in the contracts then this interface becomes a ripe area for disputes. Testing/trialling requirements under any related contracts must provide the necessary Project Company satisfaction under the EPC Contract and the offtake and supply contracts. Relevant testing issues which must be considered include:  Will any related facilities be required for the tests/trialling?  Is there consistency between obtaining handover from the Contractor under the EPC Contract and commercial operation? It is imperative to ensure that there is a sufficient window for the EPC Contract facility and any related facilities to be tested. Contractors will usually want an agreement that where the testings/trials cannot be undertaken, through no fault of its own, in a reasonable time frame the test/trials are deemed to be completed. It must not be forgotten that various certifications will be required at the Lender level. The last thing the Lenders will want is the process to be held up by their own requirements for certification. To avoid delays and disruption it is important that the Lenders’ engineer is acquainted with the details of the project and, in particular, any potential difficulties with the testing regime. Therefore, any potential problems can be identified early and resolved without impacting on the commercial operation of the facility.  Is the basis of the testing to be undertaken mirrored under both the EPC Contract and related facility? Using the methanol example above, is the gas processing plant required to produce the same quality gas that the methanol plant is to be tested/trialled, and ultimately operated on?10  On what basis are various environmental tests to be undertaken?  What measurement methodology is being used? Are the correction factors to be applied under the relevant documents uniform? Are references to international standards or guidelines to a particular edition or version?  Are all tests necessary for the Contractor to complete under the EPC Contract able to be performed as a matter of practice? Significantly, if the relevant specifications are linked to guidelines such as the international environmental guidelines, consideration must be given to changes which may occur in these guidelines. The EPC Contract reflects a snapshot of the standards existing at a time when that contract was signed. It may be a number of years post that date in which the actual construction of the project is undertaken thus allowing for possible mismatches should the legislative/guidelines have changed as regards environmental concerns. It is important that there is certainty as to which standard applies. Is it the standard at the time of entering the EPC Contract or is it the standard which applies at the time of testing? Consideration must therefore be given to the appropriate mechanism to deal with potential mismatches between the ongoing obligation of complying with laws, and the Contractor’s obligation to build to a specification agreed at a previous time. Consideration must be given to requiring satisfaction of guidelines “as amended from time to time”11. The breadth of any change of law provision will be at the forefront of any review. 10 This sounds basic but it has been a relatively common error. The same issue arises if the testing, using this example, was contingent on another related facility being able to accept some or all of the product. 11 It is often the case that if amendments to the design are required as a result the Contractor will be entitled to extensions of time and/or variations. EPC Contracts in the process plant sector PwC 193 The above issues raise the importance of the testing schedules to the EPC Contract. The size and importance of the various projects to be undertaken must mean that the days where schedules are attached at the last minute without being subject to review are gone – they are part and parcel of the EPC Contract. Discrepancies between the relevant testing and commissioning requirements will only serve to delay and distract all parties from the successful completion of testing and reliability trials. These are all areas where lawyers can add value to the successful completion of projects by being alert to and dealing with such issues at the contract formation stage. Feedstock specification issues The nature of the feedstock to be supplied to the Contractor under the EPC Contract is also another important issue. Where there is a supply agreement12 it is vitally important that adequate review is done at the EPC Contract level to ensure that the feedstock being provided under the supply agreement meets the requirements of the EPC Contract. Similar consideration will need to be given to any Project Company where it will be supplying the feedstock itself. This is a common area of dispute where the facility fails to meet the specification in test/trials. Differing feedstock specification requirements can only result in delay, cost claims and extension of time claims at the EPC Contract level. Feedstock specification issues will be hidden away in the schedules. Again, watch out for those schedules. In addition, where certain tests require specific types or quality of feedstock, the review should check that there are arrangements in place for that type of quality of feedstock to be provided. If the specification calls for a wide range of feedstock and provision is made for it to be tested as such it will be meaningless if the test cannot be undertaken. For example, the production plan might show an increase in a certain contaminant over the life of the project so a test on the lower quality feedstock may be appropriate, but only if it is possible to do so. Interface issues between a supplier or offtaker and the EPC Contractor At a fundamental level, it is imperative that the appropriate party corresponds with the relevant supplier or offtaker/system Operator during construction on issues such as the provision of offtake facilities/feedstock requirements/testing requirements and timing. The Project Company must ensure the EPC Contract states clearly that it is the appropriate party to correspond with the supplier or offtaker and the System Operator. Any uncertainty in the EPC Contract may unfortunately see the EPC Contractor dealing with the supplier or offtaker and/or the system Operator thus possibly risking the relationship of the Project Company with its customer. Significantly, it is the Project Company which must develop and nurture an ongoing and long-term relationship with the offtaker. On the other hand, it is the Contractor’s prime objective to complete the project on time or earlier at a cost which provides it with significant profit. The clash of these conflicting objectives in many cases does not allow for such a smooth process. Again, the resolution of these issues at the EPC Contract formation stage is imperative. 12 As opposed to the situations of the Operator of the new plant also supplying the feedstock, which presents its own problems. EPC Contracts in the process plant sector PwC 194 Interface issues between the operating and maintenance agreement and the EPC Contract During the transition from the construction to operating phase of the project, a number of interface issues arise which need to be addressed by both the EPC Contract and the operating and maintenance agreement. The first is commissioning. In many EPC Contracts, the Project Company is required to provide personnel to assist the Contractor with commissioning. The personnel provided by the Project Company will more than often be personnel of the Operator.13 To enable the Operator to have sufficient time to mobilise its personnel, it needs to have adequate notice of the likely date of the commencement of commissioning. This is particularly important where the Operator is not a local or domestic organisation and will be mobilising personnel from different parts of the world. An EPC Contract, therefore, must require the Contractor to give advance notice to the Project Company as to the likely date of commissioning. The second interface issue that needs to be addressed is the completion and handover of the facility. Again, the Operator will need to have sufficient notice of the likely date of completion as the commencement date under the operating and maintenance agreement (commencement of operation) will immediately follow this date. As with commissioning, the Operator will need to mobilise personnel that are not already on site assisting with commissioning. On some projects, the Contractor (or the Project Company itself depending on the identity of the Sponsor) may require the Project Company to carry out the commissioning and performance testing. In those circumstances, handover of the facility will usually take place on mechanical completion. While this arrangement may provide the Project Company with greater control of commissioning and performance testing, it creates bankability issues. For example, if the performance guarantees are not achieved or the project is not completed by the guaranteed completion date, the Contractor could argue that the acts or omissions of the Project Company prevented it from achieving the performance guarantees or completion by the guaranteed completed date. Even when such allegations are without merit they can be very difficult and expensive to disprove. For those reasons, it is preferable if the EPC Contract provides that the Contractor is responsible for commissioning and carrying out the performance tests and not the Project Company.14 Key performance clauses in process plant EPC Contracts Rationale for imposing liquidated damages Almost every construction contract will impose liquidated damages for delay and impose standards in relation to the quality of construction. Most, however, do not impose PLDs. EPC Contracts impose PLDs because the achievement of the performance guarantees has a significant impact on the ultimate success of a project. Similarly, it is important that the facility commences operation on time because of the impact on the success of the project and because of the liability the Project Company will have under other agreements. This is why DLDs are imposed. DLDs and PLDs are both sticks used to motivate the Contractor to fulfil its contractual obligations. The law of liquidated damages As discussed above, liquidated damages must be a genuine pre-estimate of the Project Company’s loss. If liquidated damages are more than a genuine pre-estimate, they will be a penalty and unenforceable. There is no legal sanction for setting a liquidated damages rate below that of a genuine pre-estimate, however, there are the obvious financial consequences. 13 See section 7.4.2 for a more detailed discussion on this issue. 14 Ibid. EPC Contracts in the process plant sector PwC 195 In addition to being unenforceable as a penalty, liquidated damages can also be void for uncertainty or unenforceable because they breach the Prevention Principle. Void for uncertainty means, as the term suggests, that it is not possible to determine how the liquidated provisions work. In those circumstances, a court will void the liquidated damages provisions. The Prevention Principle was developed by the courts to prevent Employers, ie project companies, from delaying Contractors and then claiming DLDs. It is discussed in more detail below in the context of extensions of time. Prior to discussing the correct drafting of liquidated damages clauses to ensure they are not void or unenforceable it is worth considering the consequences of an invalid liquidated damages regime. If the EPC Contract contains an exclusive remedies clause the result is simple – the Contractor will have escaped liability unless the contract contains an explicit right to claim damages at law if the liquidated damages regime fails. This is discussed in more detail below. If, however, the EPC Contract does not contain an exclusive remedies clause, the non-challenging party should be able to claim at law for damages they have suffered as a result of the challenging party’s non – or defectiveperformance. What then is the impact of the caps in the now invalidated liquidated damages clauses? Unfortunately, the position is unclear in common law jurisdictions, and a definitive answer cannot be provided based upon the current state of authority. It appears the answer varies depending upon whether the clause is invalidated due to its character as a penalty, or because of uncertainty or unenforceability. Our view of the current position is set out below. We note that whilst the legal position is not settled the position presented below does appear logical.  Clause invalidated as a penalty: When liquidated damages are unenforceable at law because they are a penalty (ie they do not represent a genuine pre-estimate of loss), the cap on liquidated damages will not act as a cap on damages claims at general law. Equity will also read down a penalty and allow appropriate compensation. This may not be an issue if the provision is less than the loss suffered. We also note that it is rare for a court to find liquidated damages are penalties in contracts between two sophisticated, welladvised parties.  Clause invalidated due to acts of prevention by the PrincipalPrincipal: When a liquidated damages clause is invalidated due to an act of prevention by the Principal for which the Contractor is not entitled to an extension of time, the liquidated damages or its cap will not act as a cap on damages claims at general law.  Clause void for uncertainty: A liquidated damages clause which is unworkable or too uncertain to ascertain what the parties intended is severed from the EPC Contract in its entirety, and will not act as a cap on the damages recoverable by the Principal from the Contractor. Upon severance, the clause is, for the purposes of contractual interpretation, ignored. However, it should be noted that the threshold test for rendering a clause void for uncertainty is high, and courts are reluctant to hold that the terms of a contract, in particular a commercial contract where performance is well advanced, are uncertain. Drafting of liquidated damages clauses Given the role liquidated damages play in ensuring EPC Contracts are bankable, and the consequences detailed above of the regime not being effective, it is vital to ensure they are properly drafted to ensure Contractors cannot avoid their liquidated damages liability on a legal technicality. Therefore, it is important, from a legal perspective, to ensure DLDs and PLDs are dealt with separately. If a combined liquidated damages amount is levied for late completion of the works, it risks being struck out as a penalty because it will over-compensate the Project Company. However, a combined liquidated damages amount levied for under-performance may under-compensate the Project Company. Our experience shows that there is a greater likelihood of delayed completion than there is of permanent underperformance. One of the reasons why projects are not completed on time is Contractors are often faced with remedying performance problems. This means, from a legal perspective, if there is a combination of DLDs and PLDs, the liquidated damages rate should include more of the characteristics of DLDs to protect against the risk of the liquidated damages being found to be a penalty. EPC Contracts in the process plant sector PwC 196 If a combined liquidated damages amount includes a NPV or performance element, the Contractor will be able to argue that the liquidated damages are not a genuine pre-estimate of loss when liquidated damages are levied for late completion only. However, if the combined liquidated damages calculation takes on more of the characteristics of DLDs the Project Company will not be properly compensated if there is permanent underperformance. Where there is significant under-performance such as a failure to meet the minimum performance guarantees, an EPC Contract will generally provide for remedies other than the payment of PLDs. For example, the range of remedies usually included in an EPC Contract in relation to the minimum performance guarantees not being met are:  the Contractor is required to replace the facility or any part of the facility and repeating the performance tests until the minimum performance guarantees are met  termination of the contract with the Project Company completing the facility or engaging a third party to do so  rejection of the facility or part of the facility in which case the Contractor must repay all sums paid by the Project Company and the cost of dismantling and clearing the facility or part of the facility  issuing a certificate of completion despite the Contractor not meeting the minimum performance guarantees with a corresponding reduction in the contract price.15 It is also important to differentiate between the different types of PLDs to protect the Project Company against arguments by the Contractor that the PLDs constitute a penalty. For example, if a single PLD’s rate is only focused on output and not efficiency, problems and uncertainties will arise if the output guarantee is met but one or more of the efficiency guarantees are not. In these circumstances, the Contractor will argue that the PLDs constitute a penalty because the loss the Project Company suffers if the efficiency guarantees are not met are usually smaller than if the output guarantees are not met. Drafting of the performance guarantee regime Now that it is clear that DLDs and PLDs must be dealt with separately it is worth considering, in more detail, how the performance guarantee regime should operate. A properly drafted performance testing and guarantee regime is important because the success or failure of the project depends, all other things being equal, on the performance of the process plant facility. The major elements of the performance regime are:  testing  guarantees  liquidated damages. Liquidated damages were discussed above. Testing and guarantees are discussed below. Testing Performance tests may cover a range of areas. Three of the most common are:  Functional tests: These test the functionality of certain parts of the facility. For example, pumps, valves, pressure vessels etc. They are usually discrete tests which do not test the facility as a whole. Liquidated damages do not normally attach to these tests. Instead, they are absolute obligations that must be complied 15 For a more detailed discussion of this issue please consult our paper on “Performance Guarantees and Remedies in EPC Contracts”. EPC Contracts in the process plant sector PwC 197 with. If not, the facility will not reach the next stage of completion (for example, mechanical completion or provisional acceptance).  Emissions tests: These test compliance against environmental requirements. Again, these are normally absolute obligations because the consequences of failure can be as severe as being forced to shut down the facility. These tests should ensure the most stringent obligations imposed on the Project Company, whether by government regulations or by Lenders, are met. Emissions tests occur at various times, including during and after performance tests. Liquidated damages are sometimes levied if the Contractor fails the emissions tests. However, given emissions tests are usually related to environmental approvals, it is likely that the facility will not be able to operate if the emissions tests are failed. Therefore, passing the emissions tests is usually an absolute obligation not linked to liquidated damages.  Performance tests: These test the ability of the facility to meet the performance criteria specified in the contract. There are often minimum and guaranteed levels of performance specified and, as discussed above, providing the minimum levels are met the consequence of failure is normally the payment of PLDs. Satisfaction of the minimum performance guarantees16 is normally an absolute obligation. The minimum performance guarantees should be set at a level of performance at which it is economic to accept the facility. Lender’s input will be vital in determining what this level is. However, it must be remembered that Lenders have different interests to the Sponsor. Lenders will, generally speaking, be prepared to accept a facility that provides sufficient income to service the debt. However, in addition to covering the debt service obligations, Sponsor will also want to receive a return on their equity investment. If that will not be provided via the sale of product because the Contractor has not met the performance guarantees, the Sponsor will have to rely on the PLDs to earn their return. In some projects, the performance tests occur after handover of the facility to the Project Company. This means the Contractor no longer has any liability for DLDs during performance testing. In our view, it is preferable, especially in project-financed projects, for handover to occur after completion of performance testing. This means the Contractor continues to be liable for DLDs until either the facility operates at the guaranteed level or the Contractor pays PLDs where the facility does not operate at the guaranteed level.17 Obviously, DLDs will be capped (usually at 20% of the contract price); therefore, the EPC Contract should give the Project Company the right to call for the payment of the PLDs and accept the facility. If the Project Company does not have this right the problem mentioned above will arise, namely, the Project Company will not have received its facility and will not be receiving any DLDs as compensation. It is common for the Contractor to be given an opportunity to modify the facility if it does not meet the performance guarantees on the first attempt. This is because the PLD amounts are normally very large and most Contractors would prefer to spend the time and the money necessary to remedy performance instead of paying PLDs. Not giving Contractors this opportunity will likely lead to an increased contract price both because Contractors will over-engineer the facility and will build a contingency for paying PLDs into the contract price. The second reason is because in most circumstances the Project Company will prefer to receive a facility that operates at 100% capacity and efficiency. The right to modify and retest is another reason why DLDs should be payable up to the time the performance guarantees are satisfied. If the Contractor is to be given an opportunity to modify and retest, the EPC Contract must deal with who bears the costs of the additional feedstock and consumables required to undertake the retesting. The cost of the feedstock in particular can be significant and should, in normal circumstances, be to the Contractor’s account because the retesting only occurs if the performance guarantees are not met at the first attempt. 16 This can be in the form of steady state testing. 17 If the contract contains a term that handover will not occur until the performance guarantees are met, there will be a regime by which this may be waived. EPC Contracts in the process plant sector PwC 198 Technical issues Ideally, the technical testing procedures should be set out in the EPC Contract. However, for a number of reasons, including the fact that it is often not possible to fully scope the testing programme until the detailed design is complete, the testing procedures are usually left to be agreed during construction by the Contractor, the Project Company’s representative or engineer and, if relevant, the Lenders’ engineer. However, a properly drafted EPC Contract should include the guidelines for testing. The complete testing procedures must, as a minimum, set out details of:  Testing methodology: Reference is often made to standard methodologies, for example, the American Society of Mechanical Engineers methodology.  Testing equipment: Who is to provide it, where it is to be located, how sensitive must it be.  Tolerances: What is the margin of error.  Ambient conditions: What atmospheric conditions are assumed to be the base case (testing results will need to be adjusted to take into account any variance from these ambient conditions).  Steady state testing: Using ordinary parameters to avoid running the plant at unsustainable shortterm rates. Provision of consumables and feedstock The responsibility for the provision of consumables and feedstock required to carry out the performance tests must be clearly set out in the EPC Contract. In general, the Project Company will be responsible for the provision of both consumables and feedstock. As the proper interpretation of the Project Company’s obligation to supply consumables is often a matter of dispute between the Project Company and Contractor, it is important for the EPC Contract to precisely identify the quality and quantity of consumables to be provided as well as the time for provision of those consumables (which should be linked to the progress of the works rather than a specific date). The responsibility for the cost of providing consumables and feedstock must also be clearly identified. This is discussed in more detail in the section on feedstock specification issues. An example of the performance testing and guarantee regime we have used on a number of projects is included in Appendix 1 of this paper. These example clauses are only extracts from a complete contract and ideally should be read as part of that entire contract and, in particular, with the clauses that deal with DLDs, PLDs, liability, the scope of the Contractor’s obligations, including any fitness for purpose warranties and termination. Nonetheless, they do provide an example of the way a performance testing and liquidated damages regime can operate. The process is best illustrated diagrammatically. Refer to the flowcharts below to see how the various parts of the performance testing regime should interface. Key general clauses in EPC Contracts Delay and extensions of time The Prevention Principle As noted previously, one of the advantages of an EPC Contract is that it provides the Project Company with a fixed completion date. If the Contractor fails to complete the works by the required date it is liable for DLDs. However, in some circumstances the Contractor is entitled to an extension of the date for completion. Failure to grant that extension can void the liquidated damages regime and set time at large. This means the Contractor is only obliged to complete the works within a reasonable time. EPC Contracts in the process plant sector PwC 199 This is the situation under common law governed contracts due to the Prevention Principle. The Prevention Principle was developed by the courts to prevent Employers, ie project companies, from delaying Contractors and then claiming DLDs. The legal basis of the Prevention Principle is unclear and it is uncertain whether you can contract out of the Prevention Principle. Logically, given most commentators believe the Prevention Principle is an equitable principle, explicit words in a contract should be able to override the principle. However, the courts have tended to apply the Prevention Principle even in circumstances where it would not, on the face of it, appear to apply. Therefore, there is a certain amount of risk involved in trying to contract out of the Prevention Principle. The more prudent and common approach is to accept the existence of the Prevention Principle and provide for it in the EPC Contract. The Contractor’s entitlement to an Extension of Time (EOT) is not absolute. It is possible to limit the Contractor’s rights and impose pre-conditions on the ability of the Contractor to claim an extension of time. A relatively standard EOT clause would entitle the Contractor to an EOT for:  an act, omission, breach or default of the Project Company  suspension of the works by the Project Company (except where the suspension is due to an act or omission of the Contractor)  a variation (except where the variation is due to an act or omission of the Contractor)  force majeure. Which cause a delay on the critical path 2 and about which the Contractor has given notice within the period specified in the contract. It is permissible (and advisable) from the Project Company’s perspective to make both the necessity for the delay to impact the critical path and the obligation to give notice of a claim for an extension of time conditions precedent to the Contractor’s entitlement to receive an EOT. In addition, it is usually good practice to include a general right for the Project Company to grant an EOT at any time. However, this type of provision must be carefully drafted because some judges have held (especially when the Project Company’s representative is an independent third party) the inclusion of this clause imposes a mandatory obligation on the Project Company to grant an extension of time whenever it is fair and reasonable to do so, regardless of the strict contractual requirements. Accordingly, from the Project Company’s perspective, it must be made clear that the Project Company has complete and absolute discretion to grant an EOT, and that it is not required to exercise its discretion for the benefit of the Contractor. Similarly, following some recent common law decisions, the Contractor should warrant that it will comply with the notice provisions that are conditions precedent to its right to be granted an EOT. We recommend using the clause in part 2 of Appendix 1 EPC Contracts in the process plant sector PwC 200 Concurrent delay You will note that in the suggested EOT clause, one of the subclauses refers to concurrent delays. This is relatively unusual because most EPC Contracts are silent on this issue. For the reasons explained below we do not agree with that approach. The Plant has or is deemed to have reached Plant Readiness Contractor commences Functional Tests, Emission Tests and Performance Tests Has any of the Functional Tests, Emission Tests or Performance Tests been interrupted or terminated for any reason Particular Functional Tests, Emission Tests and Performance Tests must be restarted Did Owner’s Representative or Contractor order cessation of Functional Tests, Emission Tests or Performance Tests due to damage to the Works, other property or personal injury being likely to result from continuation? Has the Plant failed to pass any of the Functional Tests, Emission Tests or Performance Tests or have any such Tests been stopped before its completion? Contractor must repeat particular Functional Tests. Emission Tests and Performance Tests, subject to 24 hours prior notice from Contractor to Owner’s Representative All appropriate adjustments and modifications to be made by Contractor with all reasonable speed and at its own expense prior to repetition of any Functional Tests. Contractor must produce and present written Emission Tests and Performance Tests report of results of the Functional Tests, Emission Tests and Performance Tests within seven days of completion of the Functional Tests, Emission Tests and Performance Tests Owner’s Representative must evaluate and approve results with no allowance for measurement tolerances over and above the ISO test standard Contractor to pay appropriate performance liquidated damages Contractor to pay full Delay Liquidated Damages cap Have the Minimum value Performance Guarantees been met before reaching the cap on the Delay Liquidated Damages? Has the Owner issued a Substantial Completion Certificate even though all of the requirements have not been met? Has the minimum Rated Output Performance Guarantee and the Minimum Net Heat Rate Performance Guarantee been met during Performance Tests? Has the Rated Output Performance Guarantee and Net Heat Rate Performance Guarantee been met during Performance Tests? Has the Contractor elected to pay Performance Liquidated Damages, before the expiry of the Extended Testing Period? Has the Owner required the Contractor to pay Performance Liquidated Damages before the expiry of the Extended Testing Period? Have the Maximum Performance Guarantees been met before the expiry of the Extended Testing Period? Contractor to pay pro rata Delay Liquidated Damages and Owner to issue Substantial Completion Certificate Contractor pay full Delay Liquidated Damages (cap value) and appropriate Performance Liquidated Damages and Owner to issue Substantial Completion Certificate Contractor to pay pro rata Delay Liquidated Damages and appropriate Performance Liquidated Damages and Owner to issue Substantial Completion Certificate Completion No Yes Yes Yes No No No No No And Yes Yes No No No Yes No No Yes Yes EPC Contracts in the process plant sector PwC 201 A concurrent delay occurs when two or more causes of delay overlap. It is important to note that it is the overlapping of the causes of the delays not the overlapping of the delays themselves. In our experience, this distinction is often not made. This leads to confusion and sometimes disputes. More problematic is when the contract is silent on the issue of concurrent delay and the parties assume the silence operates to their benefit. As a result of conflicting case law it is difficult to determine who, in a particular fact scenario, is correct. This can also lead to protracted disputes and outcomes contrary to the intention of the parties. There are a number of different causes of delay which may overlap with delay caused by the Contractor. The most obvious causes are the acts or omissions of a Project Company. A Project Company may have obligations to provide certain materials or infrastructure to enable the Contractor to complete the works. The timing for the provision of that material or infrastructure (and the consequences for failing to provide it) can be affected by a concurrent delay. For example, the Project Company may be obliged, as between the Project Company and the Contractor, to provide a pipeline to connect to the facility by the time the Contractor is ready to commission the facility. Given the construction of the pipeline can be expensive, the Project Company is likely to want to incur that expense as close as possible to the date commissioning is due to commence. For this reason, if the Contractor is in delay the Project Company is likely to further delay incurring the expense of building the pipeline. In the absence of a concurrent delay clause, this action by the Project Company, in response to the Contractor’s delay, could entitle the Contractor to an extension of time. Concurrent delay is dealt with differently in the various international standard forms of contract. Accordingly, it is not possible to argue that one approach is definitely right and one is definitely wrong. In fact, the “right” approach will depend on which side of the table you are sitting. In general, there are three main approaches for dealing with the issue of concurrent delay. These are:  Option one: The Contractor has no entitlement to an extension of time if a concurrent delay occurs.  Option two: The Contractor has an entitlement to an extension of time if a concurrent delay occurs.  Option three: The causes of delay are apportioned between the parties and the Contractor receives an extension of time equal to the apportionment. For example, if the causes of a 10-day delay are apportioned 60:40 Project Company:Contractor, the Contractor would receive a six-day extension of time. Each of these approaches is discussed in more detail below. Option one: Contractor not entitled to an EOT for concurrent delays A common, Project Company friendly, concurrent delay clause for this option one is: If more than one event causes concurrent delays and the cause of at least one of those events, but not all of them, is a cause of delay which would not entitle the Contractor to an extension of time under [EOT clause], then to the extent of the concurrency, the Contractor will not be entitled to an extension of time. Nothing in the clause prevents the Contractor from claiming an EOT under the general EOT clause. What the clause does do is to remove the Contractor’s entitlement to an EOT when there are two or more causes of delay and at least one of those causes would not entitle the Contractor to an EOT under the general EOT clause. For example, if the Contractor’s personnel were on strike and during that strike the Project Company failed to approve drawings, in accordance with the contractual procedures, the Contractor would not be entitled to an EOT for the delay caused by the Project Company’s failure to approve the drawings. The operation of this clause is best illustrated diagrammatically. EPC Contracts in the process plant sector PwC 202 Example one: Contractor not entitled to an EOT for concurrent delays In this example, the Contractor would not be entitled to any EOT because the Contractor Delay 2 overlaps entirely the Project Company Delay. Therefore, using the example clause above, the Contractor is not entitled to an EOT to the extent of the concurrency. As a result, at the end of the Contractor Delay 2 the Contractor would be in eight weeks’ delay (assuming the Contractor has not, at its own cost and expense, accelerated the works). Example 2: Contractor entitled to an EOT for Project Company-caused delay In this example, there is no overlap between the Contractor and Project Company Delay Event, the Contractor would be entitled to a two-week EOT for the Project Company delay. Therefore, at the end of the Project Company Delay the Contractor will remain in six weeks’ delay, assuming no acceleration. Example 3: Contractor entitled to an EOT for a portion of the Project Company-caused delay In this example, the Contractor would be entitled to a one-week EOT because the delays overlap for one week. Therefore, the Contractor is entitled to an EOT for the period when they do not overlap ie when the extent of the concurrency is zero. As a result, after receiving the one-week EOT, the Contractor would be in seven weeks’ delay, assuming no acceleration. From a Project Company’s perspective, we believe, this option is both logical and fair. For example, if, in example 2, the Project Company Delay was a delay in the approval of drawings and the Contractor Delay was the entire workforce being on strike, what logic is there in the Contractor receiving an EOT? The delay in approving drawings does not actually delay the works because the Contractor could not have used the drawings given its workforce was on strike. In this example, the Contractor would suffer no detriment from not receiving an EOT. However, if the Contractor did receive an EOT it would effectively receive a windfall gain. Contractor Delay 1 Contractor Delay 2 Project Company Delay 6 weeks 2 weeks Project Company Delay Event Contractor Delay 1 Delay Contractor Delay 1 Contractor Delay 2 6 weeks 2 weeks 2 week Project Company Delay EPC Contracts in the process plant sector PwC 203 The greater number of obligations the Project Company has the more reluctant the Contractor will likely be to accept option one. Therefore, it may not be appropriate for all projects. Option two: Contractor entitled to an EOT for concurrent delays Option two is the opposite of option one and is the position in many of the Contractor-friendly standard forms of contract. These contracts also commonly include EOT provisions to the effect that the Contractor is entitled to an EOT for any cause beyond its reasonable control which, in effect, means there is no need for a concurrent delay clause. The suitability of this option will obviously depend on which side of the table you are sitting. This option is less common than option one but is nonetheless sometimes adopted. It is especially common when the Contractor has a superior bargaining position. Option three: Responsibility for concurrent delays is apportioned between the parties Option three is a middle ground position that has been adopted in some of the standard form contracts. For example, the Australian Standards construction contract AS4000 adopts the apportionment approach. The AS4000 clause states: 34.4 Assessment When both non-qualifying and qualifying causes of delay overlap, the Superintendent shall apportion the resulting delay to WUC according to the respective causes’ contribution. In assessing each EOT the Superintendent shall disregard questions of whether: a) WUC can nevertheless reach practical completion without an EOT, or b) the Contractor can accelerate, but shall have regard to what prevention and mitigation of the delay has not been effected by the Contractor. We appreciate the intention behind the clause and the desire for both parties to share responsibility for the delays they cause. However, we have some concerns about this clause and the practicality of the apportionment approach in general. It is easiest to demonstrate our concerns with an extreme example. For example, what if the qualifying cause of delay was the Project Company’s inability to provide access to the site and the nonqualifying cause of delay was the Contractor’s inability to commence the works because it had been blackbanned by the unions. How should the causes be apportioned? In this example, the two causes are both 100% responsible for the delay. In our view, an example like the above where both parties are at fault has two possible outcomes. Either:  the delay is split down the middle and the Contractor receives 50% of the delay as an EOT; or  the delay is apportioned 100% to the Project Company and therefore the Contractor receives 100% of the time claimed. The delay is unlikely to be apportioned 100% to the Contractor because a judge or arbitrator will likely feel that that is unfair, especially if there is a potential for significant liquidated damages liability. We appreciate the above is not particularly rigorous legal reasoning, however, the clause does not lend itself to rigorous analysis. In addition, option three is only likely to be suitable if the party undertaking the apportionment is independent from both the Project Company and the Contractor. EPC Contracts in the process plant sector PwC 204 Exclusive remedies and fail safe clauses It is common for Contractors to request the inclusion of an exclusive remedies clause in an EPC Contract. However, from the perspective of a Project Company, the danger of an exclusive remedies clause is that it prevents the Project Company from recovering any type of damages not specifically provided for in the EPC Contract. An EPC Contract is conclusive evidence of the agreement between the parties to that contract. If a party clearly and unambiguously agrees that their only remedies are those within the EPC Contract, they will be bound by those terms. However, the courts have been reluctant to come to this conclusion without clear evidence of an intention of the parties to the EPC Contract to contract out of their legal rights. This means if the common law right to sue for breach of EPC Contract is to be contractually removed, it must be done by very clear words. Contractor’s perspective The main reason for a Contractor insisting on a Project Company being subject to an exclusive remedies clause is to have certainty about its potential liabilities. The preferred position for a Contractor will be to confine its liabilities to what is specified in the EPC Contract. For example, an agreed rate of liquidated damages for delay and, where relevant, underperformance of the facility. A Contractor will also generally require the amount of liquidated damages to be subject to a cap and for the EPC Contract to include an overall cap on its liability. Project company’s perspective The preferred position for a Project Company is for it not to be subject to an exclusive remedies clause. An exclusive remedies clause limits the Project Company’s right to recover for any failure of the Contractor to fulfil its contractual obligations to those remedies specified in the EPC Contract. For this reason, an exclusive remedies clause is an illogical clause to include in an EPC Contract from the perspective of a Project Company because it means that the Project Company has to draft a remedy or exception for each obligation – this represents an absurd drafting position. For example, take the situation where the EPC Contract does not have any provision for the recovery of damages other than liquidated damages. In this case, if the Contractor has either paid the maximum amount of liquidated damages or delivered the facility in a manner that does not require the payment of liquidated damages (ie it is delivered on time and performs to specification) but subsequent to that delivery the Project Company is found to have a claim, say for defective design which manifests itself after completion, the Project Company will have no entitlement to recover any form of damages as any remedy for latent defects has been excluded. The problem is exacerbated because most claims made by a Project Company will in some way relate to performance of the facility and PLDs were expressed to be the exclusive remedy for any failure of the facility to perform in the required manner. For example, any determination as to whether the facility is fit for purpose will necessarily depend on the level and standard of the performance of the facility. In addition to claims relating to fitness for purpose, a Project Company may also wish to make claims for, amongst other things, breach of contract, breach of warranty or negligence. The most significant risk for a Project Company in an EPC Contract is where there is an exclusive remedies clause and the only remedies for delay and underperformance are liquidated damages. If, for whatever reason, the liquidated damages regimes are held to be invalid, the Project Company would have no recourse against the Contractor as it would be prevented from recovering general damages at law, and the Contractor would escape liability for late delivery and underperformance of the facility. Fail safe clauses In contracts containing an exclusive remedies clause, the Project Company must ensure all necessary exceptions are expressly included in the EPC Contract. In addition, drafting must be included to allow the Project Company to recover general damages at law for delay and underperformance if the liquidated damages regimes in the EPC Contract are held to be invalid. To protect the position of a Project Company (if liquidated damages are found for any reason to be unenforceable and there is an exclusive remedies clause), we recommend the following clauses be included in the EPC Contract: EPC Contracts in the process plant sector PwC 205 [ ].1 If clause [delay liquidated damages] is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Project Company from claiming delay liquidated damages, the Project Company is entitled to claim against the Contractor damages at law for the Contractor’s failure to complete the works by the date for practical completion. [ ].2 If [ ].1 applies, the damages claimed by the Project Company must not exceed the amount specified in item [ ] of Appendix [ ] for any one day of delay and in aggregate must not exceed the percentage of the EPC Contract price specified in item [ ] of Appendix [ ]. These clauses (which would also apply to PLDs) mean that if liquidated damages are held to be unenforceable for any reason, the Project Company will not be prevented from recovering general damages at law. However, the amount of damages recoverable at law may be limited to the amount of liquidated damages that would have been recoverable by the Project Company under the EPC Contract if the liquidated damages regime had not been held to be invalid (see discussion above). For this reason, the suggested drafting should be commercially acceptable to a Contractor as its liability for delay and underperformance will be the same as originally contemplated by the parties at the time of entering into the EPC Contract. In addition, if the EPC Contract excludes the parties’ rights to claim their consequential or indirect losses, these clauses should be an exception to that exclusion. The rationale being that the rates of liquidated damages are likely to include an element of consequential or indirect losses. Force Majeure What is force majeure? Force majeure clauses are almost always included in EPC Contracts. However, they are rarely given much thought unless and until one or more parties seek to rely on them. Generally, the assumption appears to be that “the risk will not affect us” or “the force majeure clause is a legal necessity and does not impact on our risk allocation under the contract”. Both of these assumptions are inherently dangerous, and, particularly in the second case, incorrect. Therefore, especially in the current global environment, it is appropriate to examine their application. Force majeure is a civil law concept that has no real meaning under the common law. However, force majeure clauses are used in contracts because the only similar common law concept – the doctrine of frustration – is of limited application. For that doctrine to apply, the performance of a contract must be radically different from what was intended by the parties. In addition, even if the doctrine does apply, the consequences are unlikely to be those contemplated by the parties. An example of how difficult it is to show frustration is that many of the leading cases relate to the abdication of King Edward VIII before his coronation and the impact that had on contracts entered into in anticipation of the coronation ceremony. Given force majeure clauses are creatures of contract, their interpretation will be governed by the normal rules of contractual construction. Force majeure provisions will be construed strictly and in the event of any ambiguity the contra proferentem rule will apply. Contra proferentem literally means “against the party putting forward”. In this context, it means that the clause will be interpreted against the interests of the party that drafted it and is seeking to rely on it. The parties may contract out of this rule. The rule of ejusdem generis, which literally means “of the same class”, may also be relevant. In other words, when general wording follows a specific list of events, the general wording will be interpreted in light of the specific list of events. In this context it means that when a broad catch-all phrase, such as “anything beyond the reasonable control of the parties”, follows a list of more specific force majeure events the catch-all phrase will be limited to events analogous to the listed events. Importantly, parties cannot invoke a force majeure clause if they are relying on their own acts or omissions. The underlying test in relation to most force majeure provisions is whether a particular event was within the contemplation of the parties when they made the contract. The event must also have been outside the control of the contracting party. There are generally three essential elements to force majeure:  it can occur with or without human intervention.  it cannot have reasonably been foreseen by the parties. EPC Contracts in the process plant sector PwC 206  it was completely beyond the parties’ control and they could not have prevented its consequences. Given the relative uncertainty surrounding the meaning of force majeure, we favour explicitly defining what the parties mean. This takes the matter out of the hands of the courts and gives control back to the parties. Therefore, it is appropriate to consider how force majeure risk should be allocated. Drafting force majeure clauses The appropriate allocation of risk in project agreements is fundamental to negotiations between the Project Company and its Contractors. Risks generally fall into the following categories:  risks within the control of the Project Company.  risks within the control of the Contractor.  risks outside the control of both parties. The negotiation of the allocation of many of the risks beyond the control of the parties, for example, latent site conditions and change of law, is usually very detailed so that it is clear which risks are borne by the Contractor. The same approach should be adopted in relation to the risks arising from events of force majeure. There are two aspects to the operation of force majeure clauses:  the definition of force majeure events.  the operative clause that sets out the effect on the parties’ rights and obligations if a force majeure event occurs.18 The events which trigger the operative clause must be clearly defined. As noted above, given the common law meaning of the term force majeure is not certain and is open to interpretation of the courts, it is in the interests of both parties to ensure that the term force majeure is clearly defined. The preferred approach for a Project Company is to define force majeure events as being any of the events in an exhaustive list set out in the contract. In this manner, both parties are aware of which events are force majeure events and which are not. Clearly, defining force majeure events makes the administration of the contract and, in particular, the mechanism within the contract for dealing with force majeure events simpler and more effective. An example exhaustive definition is: An Event of Force Majeure is an event or circumstance which is beyond the control and without the fault or negligence of the party affected and which by the exercise of reasonable diligence the party affected was unable to prevent provided that event or circumstance is limited to the following: a) Riot, war, invasion, act of foreign enemies, hostilities (whether war be declared or not), acts of terrorism, civil war, rebellion, revolution, insurrection of military or usurped power, requisition or compulsory acquisition by any governmental or competent authority b) Ionising radiation or contamination, radioactivity from any nuclear fuel or from any nuclear waste from the combustion of nuclear fuel, radioactive toxic explosive or other hazardous properties of any explosive assembly or nuclear component c) Pressure waves caused by aircraft or other aerial devices travelling at sonic or supersonic speeds 18 A common failing of force majeure in some negotiations is to focus on the definitional issues rather than the consequences. Both issues are important. EPC Contracts in the process plant sector PwC 207 d) Earthquakes, flood, fire or other physical natural disaster, but excluding weather conditions regardless of severity e) Strikes at national level or industrial disputes at a national level, or strike or industrial disputes by labour not employed by the affected party, its sub contractors or its suppliers and which affect an essential portion of the Works but excluding any industrial dispute which is specific to the performance of the Works or this Contract. An operative clause will act as a shield for the party affected by the event of force majeure so that a party can rely on that clause as a defence to a claim that it has failed to fulfil its obligations under the contract. An operative clause should also specifically deal with the rights and obligations of the parties if a force majeure event occurs and affects the project. This means the parties must consider each of the events it intends to include in the definition of force majeure events and then deal with what the parties will do if one of those events occurs. An example of an operative clause is: [ ].1 Neither party is responsible for any failure to perform its obligations under this Contract, if it is prevented or delayed in performing those obligations by an Event of Force Majeure [ ].2 Where there is an Event of Force Majeure, the party prevented from or delayed in performing its obligations under this Contract must immediately notify the other party giving full particulars of the Event of Force Majeure and the reasons for the Event of Force Majeure preventing that party from, or delaying that party in performing its obligations under this Contract and that party must use its reasonable efforts to mitigate the effect of the Event of Force Majeure upon its or their performance of the Contract and to fulfil its or their obligations under the Contract [ ].3 Upon completion of the Event of Force Majeure the party affected must as soon as reasonably practicable recommence the performance of its obligations under this Contract. Where the party affected is the Contractor, the Contractor must provide a revised programme rescheduling the Works to minimise the effects of the prevention or delay caused by the Event of Force Majeure [ ].4 An Event of Force Majeure does not relieve a party from liability for an obligation which arose before the occurrence of that event, nor does that event affect the obligation to pay money in a timely manner which matured prior to the occurrence of that event [ ].5 The Contractor has no entitlement and the Project Company has no liability for: a) Any costs, losses, expenses, damages or the payment of any part of the Contract Price during an Event of Force Majeure. b) Any delay costs in any way incurred by the Contractor due to an Event of Force Majeure. In addition to the above clause, it is critical to deal appropriately with other issues that will arise if a force majeure event occurs. For example, as noted above, it is common practice for a Contractor to be entitled to an extension of time if a force majeure event impacts on its ability to perform the works. Contractors also often request costs if a force majeure event occurs. In our view, this should be resisted. Force majeure is a neutral risk in that it cannot be controlled by either party. Therefore, the parties should bear their own costs and neither party should be penalised. Another key clause that relates to force majeure type events is the Contractor’s responsibility for care of the works and the obligation to reinstate any damage to the works prior to completion. A common example clause is: [ ].1 The Contractor is responsible for the care of the Site and the Works from when the Project Company makes the Site available to the Contractor until 5.00pm on the Date of Commercial Operation. [ ].2 The Contractor must promptly make good loss from, or damage to, any part of the Site and the Works while it is responsible for their care. EPC Contracts in the process plant sector PwC 208 [ ].3 If the loss or damage is caused by an Event of Force Majeure, the Project Company may direct the Contractor to reinstate the Works or change the Works. The cost of the reinstatement work or any change to the Works arising from a direction by the Project Company under this clause will be dealt with as a Variation except to the extent that the loss or damage has been caused or exacerbated by the failure of the Contractor to fulfil its obligations under this Contract. [ ].4 Except as contemplated in clause [ ].3, the cost of all reinstatement Works will be borne by the Contractor. This clause is useful because it enables the Project Company to, at its option, have the damaged section of the project rebuilt as a variation to the existing EPC Contract. This will usually be cheaper than recontracting for construction of the damaged sections of the works. Operation and Maintenance Operating and maintenance manuals The Contractor is usually required to prepare a detailed Operating and Maintenance Manual (O&M manual). The EPC Contract should require the Contractor to prepare a draft of the O&M manual within a reasonable time to enable the Project Company, the Operator and possibly the Lenders to provide comments, which can be incorporated into a final draft at least six months before the start of commissioning. The draft should include all information which may be required for start-up, all modes of operation during normal and emergency conditions and maintenance of all systems of the facility. Operating and maintenance personnel It is common for the Contractor to be obliged to train the operations and maintenance staff supplied by the Project Company. The cost of this training will be built into the contract price. It is important to ensure the training is sufficient to enable such staff to be able to efficiently, prudently, safely and professionally operate the facility upon commercial operation. Therefore, the framework for the training should be described in the Appendix dealing with the scope of work (in as much detail as possible). This should include the standards of training and the timing for training. The Project Company’s personnel trained by the Contractor will also usually assist in the commissioning and testing of the facility. They will do this under the direction and supervision of the Contractor. Therefore, absent specific drafting to the contrary, if problems arise during commissioning and/or testing the Contractor can argue they are entitled to an extension of time etc. We recommend inserting the following clause: [ ].1 The Project Company must provide a sufficient number of competent and qualified operating and maintenance personnel to assist the Contractor to properly carry out Commissioning and the Commercial Operation Performance Tests. [ ].2 Prior to the Date of Commercial Operation, any act or omission of any personnel provided by the Project Company pursuant to GC [ ].1 is, provided those personnel are acting in accordance with the Contractor’s instructions, directions, procedures or manuals, deemed to be an act or omission of the Contractor and the Contractor is not relieved of its obligations under this Contract or have any claim against the Project Company by reason of any act or omission. Spare parts The Contractor is usually required to provide, as part of its scope of works, a full complement of spare parts (usually specified in the appendices (the scope of work or the specification)) to be available as at the commencement of commercial operation. Further, the Contractor should be required to replace any spare parts used in rectifying defects during the defects liability period, at its sole cost. There should also be a time limit imposed on when these spare parts must be back in the store. It is normally unreasonable to require the spare parts to have been replaced by the expiry of the defects liability period because that may, for some long lead time items, lead to an extension of the defects liability period. EPC Contracts in the process plant sector PwC 209 The Project Company also may wish to have the option to purchase spares parts from the Contractor on favourable terms and conditions (including price) after the expiry of the defects liability period. In that case it would be prudent to include a term which deals with the situation where the Contractor is unable to continue to manufacture or procure the necessary spare parts. This provision should cover the following points:  written notification from the Contractor to the Project Company of the relevant facts, with sufficient time to enable the Project Company to order a final batch of spare parts from the Contractor.  the Contractor should deliver to, or procure for, the Project Company (at no charge to the Project Company), all drawings, patterns and other technical information relating to the spare parts.  the Contractor must sell to the Project Company (at the Project Company’s request) at cost price (less a reasonable allowance for depreciation) all tools, equipment and moulds used in manufacturing the spare parts, to the extent they are available to the Contractor provided it has used its reasonable endeavours to procure them. The Contractor should warrant that the spare parts are fit for their intended purpose, and that they are of merchantable quality. At worst, this warranty should expire on the later of:  the manufacturer’s warranty period on the applicable spare part; or  the expiry of the defects liability period. Dispute resolution Dispute resolution provisions for EPC Contracts could fill another entire paper. There are numerous approaches that can be adopted depending on the nature and location of the project and the particular preferences of the parties involved. However, there are some general principles which should be adopted. They include:  having a staged dispute resolution process that provides for internal discussions and meetings aimed at resolving the dispute prior to commencing action (either litigation or arbitration)  obliging the Contractor to continue to execute the works pending resolution of the dispute  not permitting commencement of litigation or arbitration, as the case may be, until after commercial operation of the facility. This provision must make provision for the parties to seek urgent interlocutory relief ie injunctions and to commence proceedings prior to the expiry of any limitations period. If the provision does not include these exceptions it risks being unenforceable  providing for consolidation of any dispute with other disputes which arise out of or in relation to the construction of the facility. The power to consolidate should be at the Project Company’s discretion We have prepared a paper which details the preferred approach to be taken in respect of dispute resolution regimes in various Asian jurisdictions including the PRC, Philippines, Thailand, Vietnam and Taiwan. You should consult this paper if you want more information on this topic. PwC 210 Appendix 1 Example clauses Part 1 – Performance testing and guarantee regime Tests and Inspections [ ].1 The Contractor must, at its own expense, carry out at the place of manufacture and/or on the site all tests and/or inspections of the equipment and any part of the works as specified in this contract or as required by any applicable laws, and as necessary to ensure the facility operates safely and reliably under the conditions specified in the schedule of scope of work and the schedule of tests. [Appendix 1 should specify all the categories of tests other than the tests (eg test at manufacturers plant, test on site, functional test etc.)] [ ].2 The Contractor must also comply with any other requirements of the Owner in relation to testing and inspection. [ ].3 The Owner and the Lenders’ representative are entitled to attend any test and/or inspection by its appointed duly authorised and designated inspector. [ ].4 Whenever the Contractor is ready to carry out any test and/or inspection, the Contractor must give a reasonable advance notice to the Owner of the test and/or inspection and of the place and time. The Contractor must obtain from any relevant third party or manufacturer any necessary permission or consent to enable the Owner’s inspector and the Lenders’ representative to attend the test and/or inspection. [ ].5 The Contractor must provide the Owner’s representative with a certified report of the results of any test and/or inspection within five days of the completion of that test or inspection. [ ].6 If the Owner or the Lenders’ representative fails to attend the test and/or inspection, or if it is agreed between the parties that the Owner or the Lenders’ representative will not attend, then the Contractor may proceed with the test and/or inspection in the absence of the Owner’s inspector and provide the Owner and the Lenders’ representative with a certified report of the results. [ ].7 The Owner may require the Contractor to carry out any test and/or inspection not described in this contract. The Contractor’s extra costs necessarily incurred, which do not include head office or corporate overheads, profit or loss of profit, in the carrying out of the test and/or inspection will be added to the contract price only if the test shows that the relevant works conform with the requirements of the contract, but otherwise all costs will be borne by the Contractor. [ ].8 If any equipment or any part of the works fails to pass any test and/or inspection, the Contractor must either rectify to the Owner’s satisfaction or replace such equipment or part of the works and must repeat the test and/or inspection upon giving a notice under GC [ ].4. [ ].9 The Contractor must afford the Owner and the Lenders’ representative access at any time to any place where the equipment is being manufactured or the works are being performed in order to inspect the progress and the manner of manufacture or construction, provided that the Owner gives the Contractor reasonable prior notice. The Owner, Owner’s representative and the Lenders’ representative will have the right to examine and have access to documents relating to the manufacture and assembly of the equipment including the quality control and inspection documentation. [ ].10 The Contractor agrees that neither the execution of a test and/or inspection of equipment or any part of the works, nor the attendance by either or both the Owner and the Lenders’ representative nor the issue of any test report pursuant to GC [ ].5 releases the Contractor from any other responsibilities under this contract. Example clauses PwC 211 [ ].11 No part of the works are to be covered up on the site without carrying out any test and/or inspection required under this contract and the Contractor must give reasonable notice to the Owner whenever any part of the works are ready or about to be ready for test and/or inspection. [ ].12 The Contractor must uncover any part of the works or make openings in or through the same as the Owner may from time to time require at the site and must reinstate and make good that part. [ ].13 If any part of the works have been covered up at the site after compliance with the requirement of GC [ ].12 and are found to be performed in accordance with the contract, the Contractor’s extra costs, which do not include head office or corporate overheads, profit or loss of profit, necessarily incurred in uncovering, making openings in or through, reinstating and making good the same will be added to the contract price. Performance tests, procedures and guidelines [ ].14 The performance tests must be conducted by the Contractor after commissioning to ascertain whether the facility can achieve completion and to ascertain whether the facility can meet the performance guarantees. [ ].15 All performance tests must be conducted in a professional, timely, safe and environmentally responsible manner and in accordance with the schedule of scope of work and the schedule of tests, all other terms and conditions of this contract, applicable standards, laws, government approvals and must be accomplished at no additional cost or expense to the Owner. [ ].16 The facility must not be operated during any performance test in excess of: a The limits allowed by any manufacturer to maintain its warranty b The limits imposed by the law and government approvals applicable standards c The limits stated in the schedule of tests [ ].17 The Contractor agrees that the Owner and the Lenders’ representative will monitor the conduct of the performance testing to ensure compliance with the terms and conditions of this contract. [ ].18 The Contractor agrees that an inspection pursuant to GC [ ].17 by the Owner and/or the Lenders’ representative does not release the Contractor from any other responsibilities under this contract, including meeting the performance guarantees. [ ].19 If a performance test is interrupted or terminated, for any reason, such performance test, must be restarted from the beginning, unless otherwise approved by the Owner or the Lenders’ representative. [ ].20 The Owner or the Contractor is entitled to order the cessation of any performance test if: a Damage to the works, the facility or other property or personal injury b Breach of the conditions specified in the relevant environmental laws or government approvals, is likely to result from continuation [ ].21 If the Contractor fails to pass a performance test (or any repetition in the event of prior failure) or if a performance test is stopped before its completion, such performance test must, subject to 24 hours’ prior notice having been given by the Contractor to the Owner and the Lenders’ representative, be repeated as soon as practicable. All appropriate adjustments and modifications are to be made by the Contractor with all reasonable speed and at its own expense before the repetition of any performance test. [ ].22 The results of the performance tests must be presented in a written report, produced by the Contractor and delivered to the Owner and the Lenders’ representative within five days of the completion of the tests. Those results will be evaluated by the Owner and the Lenders’ representative. In evaluation of the results, no additional allowance will be made for measurement tolerances over and above those specified in the applicable ISO standard or other relevant test standard. Example clauses PwC 212 [ ].23 Despite any other provision of this contract, the Owner is entitled to all products and revenues generated or earned during precommissioning, commissioning and the performance tests. Mechanical completion, precommissioning and commissioning [ ].1 Mechanical completion (a) As soon as the facility, in the opinion of the Contractor, reaches the stage of mechanical completion the Contractor must give a notice to the Owner’s representative. (b) The Owner’s representative must, promptly, and no later than five days after receipt of the Contractor’s notice under GC [ ].1(a), either issue a certificate of mechanical completion stating that the facility has reached mechanical completion or notify the Contractor of any defects and/or deficiencies. (c) If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct those defects and/or deficiencies and the procedures described in GCs [ ].1(a) and (b) must be repeated until the Owner issues a certificate of mechanical completion. [ ].2 Precommissioning After the Owner’s representative has issued a certificate of mechanical completion to the Contractor under GC [ ].1(b), the Contractor must commence precommissioning of the facility in accordance with the Owner’s requirements and procedures in relation to precommissioning as set out in the schedule of scope of work. [ ].3 Commissioning (a) After the successful completion of precommissioning under GC [ ].2 the Contractor must give the Owner a notice that the facility is ready for commissioning. (b) The Contractor must, as soon as reasonably practicable after receipt of a notice under GC [ ].3(a), issue a notice to the Contractor specifying the date for commencement of commissioning. (c) On the date specified in the notice issued under GC [ ].3(b), the Contractor must commence commissioning of the facility in accordance with the Owner’s requirements and procedures in relation to commissioning as set out in the schedule of scope of work. Performance tests, completion and final completion [ ].1 Performance tests (a) After the successful completion of commissioning, the Contractor must give a notice to the Owner’s representative that the facility, or that part, is ready for the performance tests and the emissions test. (b) The Owner’s representative must, as soon as reasonably practicable, after receipt of a notice under GC [ ].1(a), issue a notice to the Contractor specifying the date for commencement of those performance tests if that date is not already identified in the programme and the schedule of tests. [ ].2 Completion (a) As soon as the facility has passed the performance tests and the emissions test and, in the opinion of the Contractor, the facility has reached the stage of completion, the Contractor must give a notice to the Owner’s representative. (b) The Owner’s representative must, promptly, and no later than five days after receipt of the Contractor’s notice under GC [ ].2(a), either issue a certificate of completion stating that the facility has reached completion or notify the Contractor of any defects and/or deficiencies. Example clauses PwC 213 (c) If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct those defects and/or deficiencies and the procedures described in GCs [ ].2(a) and (b) must be repeated until the Owner issues a certificate of completion. (d) Despite any other provision of this contract, no partial or entire use or occupancy of the site, the works or the facility by the Owner, whether during the performance tests, or otherwise, in any way constitutes an acknowledgment by the Owner that completion has occurred, nor does it operate to release the Contractor from any of its warranties, obligations or liabilities under this contract. (e) Upon the issue of the certificate of completion, the Contractor must hand over care, custody and control of the facility to the Owner. (f) Notwithstanding that all the requirements for the issuing of a certificate of completion have not been met, the Owner may at any time, in its absolute discretion, issue a certificate of completion. The issue of a certificate of completion in accordance with this GC [ ].2(f) will not operate as an admission that all the requirements of completion have been met and does not prejudice any of the Owner’s rights, including the right to require the Contractor to satisfy all these requirements. [ ].3 Final completion (a) As soon as the facility, in the opinion of the Contractor, reaches the stage of final completion the Contractor must give a notice to the Owner. (b) The Owner’s representative must, promptly, and no later than five days after receipt of the Contractor’s notice under GC [ ].3(a), either issue a certificate of final completion stating that the facility has reached final completion or notify the Contractor of any defects and/or deficiencies. (c) If the Owner’s representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct those defects and/or deficiencies and the procedures described in GCs [ ].3(a) and (b) must be repeated until the Owner issues a certificate of final completion. (d) Despite any other provision of this contract, no partial or entire use or occupancy of the site, the works or the facility by the Owner, whether during the performance tests or otherwise, in any way constitutes an acknowledgment by the Owner that final completion has occurred, nor does it operate to release the Contractor from any of its warranties, obligations or liabilities under this contract including the satisfactory performance of its obligations during the defects liability period, the carrying out of the performance tests and meeting the performance guarantees and the emissions guarantee. Performance guarantee [ ].1 Performance guarantees (a) The Contractor guarantees that the facility and all parts will meet the performance guarantees and emissions guarantee as specified in the schedule of performance guarantees and the schedule of tests. (b) The Contractor agrees that the emissions guarantee is an absolute guarantee the meeting of which is a condition precedent to achieving completion. [ ].2 Minimum performance guarantees not met (a) If, for reasons not attributable to the Owner, the minimum performance guarantees are not met, the Contractor must at its cost and expense make changes, modifications and/or additions to the facility or any part as may be necessary to meet at least the minimum performance guarantees. The Contractor must notify the Owner upon completion of the necessary changes, modifications and/or additions and must, subject to the Owner’s rights under GCs [ ].2, [ ].14 and [ ] [Termination], repeat the overall performance test until the minimum performance guarantees have been met. Nothing in this GC [ ].2 derogates from the Contractor’s obligation to meet the performance guarantees. Example clauses PwC 214 (b) Despite this GC [ ] or any other provision of this contract, if for reasons not attributable to the Owner, the Contractor does not meet the minimum performance guarantees after two repetitions of the overall performance test the Owner may: (i) Reject the facility or any part of the facility and the provisions of GC [ ].3 will apply. (ii) Require the Contractor to: (A) replace the facility or any part of the facility with all due dispatch and in compliance with the requirements of the contract; and (B) repeat the performance tests and the overall performance test. (iii) Terminate the contract and, at the Contractor’s risk, complete or procure completion of the works in accordance with the contract; or (iv) Require the Owner’s representative to issue a certificate of completion notwithstanding that the minimum performance guarantees have not been met. The contract price will then be reduced by such amount as determined by the Owner’s representative. [ ].3 Consequences of termination or rejection (a) If the Owner rejects the facility or any part of the facility under GC [ ].2(b)(i), the Owner will be entitled to recover: (i) All sums paid by the Owner in respect of such part(s) of the facility. (ii) The cost of dismantling those part(s) of the facility. (iii) The cost of clearing the site as appropriate and returning the facility or part thereof to the Contractor. (b) If the Owner terminates the contract pursuant to GC [ ].2(b)(iii), then in addition to any delay liquidated damages which may be due for delay under GC [ ].2, it will be entitled to recover from the Contractor any loss (including but not limited to any construction and financing costs whether or not determined to be direct loss) it suffers in completing the relevant works to the extent that such loss exceeds the amount that would have been paid by the Owner to the Contractor under the contract had the relevant works been completed by the Contractor in accordance with the contract as well as any amounts payable under the financing agreements, as a result of the Contractor failing to meet the minimum performance guarantees. [ ].4 Satisfaction of performance guarantees Provided the minimum performance guarantees have been met, the payment of performance liquidated damages under GCs, [ ].6, [ ].7 and/or [ ]9 (as the case may be) will be in satisfaction of the relevant performance guarantee. [ ].5 Minimum performance guarantees met, but not performance guarantees Subject to GCs [ ].4, [ ].6 and [ ].7, if, for reasons not attributable to the Owner, the performance guarantees are not met, but the minimum performance guarantees are met during the same overall performance test, the Contractor must, prior to the expiration of the extended remediation period: (a) At its cost and expense make changes, modifications and/or additions to the facility or any part as may be necessary to meet the performance guarantees. (b) Notify the Owner upon completion of the necessary changes, modifications and/or additions. (c) Repeat the overall performance test until the performance guarantees have been met during the same overall performance test. Example clauses PwC 215 [ ].6 Performance liquidated damages If the Contractor does not, for reasons not attributable to the Owner, during the same overall performance test, meet the performance guarantees by the expiration of the extended remediation period, but the minimum performance guarantees are met, the Contractor must pay performance liquidated damages calculated in accordance with schedule of performance liquidated damages. [ ].7 Extended remediation period (a) Despite GCs [ ].5 and [ ].6, the Contractor may at any time during the extended remediation period elect to pay performance liquidated damages in respect of the failure to meet any or all of the performance guarantees (for reasons not attributable to the Owner) provided the minimum performance guarantees and the emissions guarantees have been met. (b) Despite GCs [ ].5 and [ ].6, the Owner may at any time, one month after the date for completion, require the Contractor to pay performance liquidated damages in respect of the failure to meet any or all of the performance guarantees (for reasons not attributable to the Owner) provided the minimum performance guarantees have been met. [ ].8 Aggregate liability The aggregate liability of the Contractor for performance liquidated damages under GC [ ].9 will not exceed the amount calculated in accordance schedule of performance liquidated damages. [ ].9 General Performance liquidated damages must be invoiced by the Owner and payment must be made within 15 days of the date of the invoice. At the expiration of 15 days, the amount involved will be a debt due and payable to the Owner on demand and the Owner may also have recourse to the security provided under this contract. [ ].10 Fair and reasonable pre-estimate The parties agree that the performance liquidated damages in the schedule of performance liquidated damages are a fair and reasonable pre-estimate of the damages likely to be sustained by the Owner if the Contractor meets the minimum performance guarantees but fails to meet the performance guarantees. [ ].11 Completion Provided the minimum performance guarantees have been met and subject to [ ].1(b), the payment of performance liquidated damages in relation to the performance guarantees under this [ ].11 is in complete satisfaction of the Contractor’s guarantees under GC [ ].1. Upon the payment of the performance liquidated damages by the Contractor, the Owner must, subject to all other conditions to achieving completion having been satisfied, issue the certificate of completion for the facility or any part in respect of which the performance liquidated damages have been paid. [ ].12 Performance liquidated damages additional to delay liquidated damages The payment of performance liquidated damages and the Contractor’s other obligations and liabilities under this GC [ ] are in addition to any liability of the Contractor for delay liquidated damages under GC [ ]. [ ].13 Rights at law If this GC [ ] (or any part) is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Owner from claiming performance liquidated damages, the Owner is entitled to claim against the Contractor for damages at law for the Contractor’s failure to meet the performance guarantees. Those damages must not exceed the amounts specified in the schedule of performance liquidated damages. Example clauses PwC 216 [ ].14 No benefit The Contractor is not entitled to the benefit of the exclusion in GC [ ] [Prohibition on claiming consequential loss] in any claim for damages at law by the Owner against the Contractor pursuant to GC [ ].13 for the Contractor’s failure to meet any or all of the performance guarantees. Part 2 – Extension of time regime [ ].1 The Contractor must immediately give notice to the Project Company of all incidents and/or events of whatsoever nature affecting or likely to affect the progress of the works. [ ].2 Within 15 days after an event has first arisen the Contractor must give a further notice to the Project Company which must include: (a) the material circumstances of the event including the cause or causes. (b) the nature and extent of any delay. (c) the corrective action already undertaken or to be undertaken. (d) the effect on the critical path noted on the programme. (e) the period, if any, by which in its opinion the date for commercial operation should be extended. (f) a statement that it is a notice pursuant to this GC [ ].2. [ ].3 Where an event has a continuing effect or where the Contractor is unable to determine whether the effect of an event will actually cause delay to the progress of the works so that it is not practicable for the Contractor to give notice in accordance with GC [ ].2, a statement to that effect with reasons together with interim written particulars (including details of the likely consequences of the event on progress of the works and an estimate of the likelihood or likely extent of the delay) must be submitted in place of the notice required under GC [ ].2. The Contractor must then submit to the Project Company, at intervals of 30 days, further interim written particulars until the actual delay caused (if any) is ascertainable, whereupon the Contractor must as soon as practicable but in any event within 30 days give a final notice to the Project Company including the particulars set out in GC [ ].2. [ ].4 The Project Company must, within 30 days of receipt of the notice in GC [ ].2 or the final notice in GC [ ].3 (as the case may be), issue a notice notifying the Contractor’s representative of its determination as to the period, if any, by which the date for completion is to be extended. [ ].5 Subject to the provisions of this GC [ ], the Contractor is entitled to an extension of time to the date for completion as the Project Company assesses, where a delay to the progress of the works is caused by any of the following events, whether occurring before, on or after the date for completion: (a) Any act, omission, breach or default by the Project Company, the Project Company’s representative and their agents, employees and Contractors. (b) A variation, except where that variation is caused by an act, omission or default of the Contractor or its sub contractors, agents or employees. (c) A suspension of the works pursuant to GC [ ], except where that suspension is caused by an act, omission or default of the Contractor or its sub contractors, agents or employees. (d) An event of force majeure. (e) A change of law. [ ].6 Despite any other provisions of this GC [ ], the Project Company may at any time and in its absolute discretion make a fair and reasonable extension of the date for completion. Example clauses PwC 217 [ ].7 The Contractor must constantly use its best endeavours to avoid delay in the progress of the works. [ ].8 If the Contractor fails to submit the notices required under GCs [ ].1, [ ].2 and [ ].3 within the times required then: (a) The Contractor has no entitlement to an extension of time. (b) The Contractor must comply with the requirements to perform the works by the date for completion. (c) Any principle of law or equity (including those which might otherwise entitle the Contractor to relief and the Prevention Principle) which might otherwise render the date for completion immeasurable and liquidated damages unenforceable, will not apply. [ ].9 It is a further condition precedent of the Contractor’s entitlement to an extension of time that the critical path noted on the programme is affected in a manner which might reasonably be expected to result in a delay to the works reaching completion by the date for completion. [ ].10 If there are two or more concurrent causes of delay and at least one of those delays would not entitle the Contractor to an extension of time under this GC [ ] then, to the extent of that concurrency, the Contractor is not entitled to an extension of time. [ ].11 The Project Company may direct the Contractor’s representative to accelerate the works for any reason including as an alternative to granting an extension of time to the date for completion. [ ].12 The Contractor will be entitled to all extra costs necessarily incurred, by the Contractor in complying with an acceleration direction under GC [ ].11, except where the direction was issued as a consequence of the failure of the Contractor to fulfil its obligations under this contract. The Project Company must assess and decide as soon as reasonably practical, the extra costs necessarily incurred by the Contractor. PwC 218 8 EPCM Contracts: Project delivery through engineering, procurement and construction management contracts Introduction There has been a significant shift in contracting strategy within the construction market in recent years, particularly regarding traditional risk allocation. In many countries enjoying favourable economic conditions, it is no longer unusual to see Contractors refusing to bid for the usual fixed price and time contracts. This change is partly driven by Contractors becoming more sophisticated in their risk analysis, but also largely due to:  the current surge in demand in the global construction and engineering sectors  the significant size, complexity and profile of so-called “mega projects”  the shortage of Contractors with the experience and resources needed to deliver such mega projects  the shortage of experienced labour and quality materials and resultant fluctuations in associated costs. Increasingly, Owners and Contractors are looking for alternatives to the traditional fixed price and time project delivery methods. While the traditional delivery methods remain (such as design and build; Engineering, Procurement and Construction (EPC); and construct only), the risk allocation and payment arrangements vary significantly. This paper provides a brief review on the traditional fixed time and cost arrangements and, in the Engineering, Procurement and Construction Management (EPCM) context:  provides an overview of the main features  examines each phase of the EPCM delivery method  discusses other issues, including bankability and Key Performance Indicator (KPI) arrangements. Delivery by traditional fixed time and cost arrangements Over the past 10-15 years, project delivery methods have generally incorporated some form of fixed time and cost arrangement – whether by construct only, design and build or EPC. These delivery methods were, and remain, popular with Owners and Financiers as the fixed time and cost arrangement provides certainty and, for EPC Contracts, a single source of responsibility. Delay liquidated damages may be levied against the Contractor so as to incentivise them to complete the works on time and the circumstances where the Contractor can claim relief for increases in the cost are carefully limited. Naturally, Contractors seek to price a risk premium into their remuneration to deal with such risk allocation. Where projects are delivered on a limited or non-recourse financing basis, the need for time and price certainty is magnified. While the recent forces of demand and supply in the construction industry have also impacted the risk allocation on the “turnkey” EPC Contracts used for such projects, and bank credit committees have relaxed requirements slightly (credit crunch aside), the change in risk allocation has been far more limited. EPCM Contracts: Project delivery through engineering, procurement and construction management contracts PwC 219 * including designers, engineers and construction managers – where limited or non-recourse financing is in place Overview of EPCM arrangements The concept of delivering projects by way of an EPCM Contract is not new. It has wavered in popularity for a number of decades and has, for some time, been used extensively throughout the oil, gas, petrochemical and resources industries. In the current market, sophisticated Owners are often not prepared to pay large risk premiums and profits to Contractors under traditional fixed time and cost contracts. Add to this, the current “boom” in the number of projects to be delivered across the globe, increased pressure to fast-track delivery, limitations on Owners’ resources, rising prices of materials and labour, and we are witnessing a redefining of the way projects are being delivered. EPCM Contracting is just one of a number of alternative models becoming more wide spread. Delivering an EPCM project means different things to many participants. The form and structure of an EPCM Contract will vary depending on a variety of factors such as the:  particular industry and project  sophistication and expertise of the project parties  owner’s requirements as to level of involvement  owner’s internal project delivery resources/and skill set  history and level of trust between the Owner and the Contractor  level of integration between the project parties’ respective teams  level of risk on the project (ie technical and commercial/financial). In its simplest form, an EPCM Contract is a consultancy agreement for the provision of professional or technical services. At one end of the spectrum, an EPCM could be considered to be a pure consultancy-type arrangement and, at the other end, an integrated EPCM Contract could look more akin to an integrated alliance style contract. The EPCM Contractor is typically responsible for:  basic and detailed design and engineering  establishing, implementing and managing tendering processes for procurement of all equipment and materials and awarding and managing works package contracts  overall project management and administration of work package contracts, including during warranty periods. Owner EPC Contractor Lenders Subcontractor A Suppliers Consultants* EPCM Contracts: Project delivery through engineering, procurement and construction management contracts PwC 220 Traditionally, the Owner entered into the construction and procurement agreements for the project. However, depending on the project structure, the Owner and the industry, the EPCM Contractor may enter into contracts directly with Contractors and suppliers, as agent for the Owner, (with the EPCM Contractor assuming no or limited liability under such contracts). Where this is the case, there are generally clear procedures and limitations on the EPCM Contractor’s ability to execute such contracts. EPCM Contractors usually do not take full responsibility for:  delivery of the project by certain key milestone dates  care and custody of the works (with certain exceptions for arranging security and management of safety etc.)  the project being delivered in accordance with the project budget. The EPCM Contractor is usually heavily incentivised to bring the project to commercial operation on time and under budget, but is not required to indemnify the Owner for failing to do so. Depending on the scope of services to be provided by the EPCM Contractor, potential liabilities may relate to wilful default, fraudulent behaviour and, after some form of negligence or recklessness, in respect of matters such as:  performance of the design and engineering  preparation of the project budget and project schedule  management of procurement, including a failure to implement an objective and competitive tender process  management, administration and supervision of the work packages  coordination of the design and construction works between works package Contractors. Ordinarily, the maximum liability of the EPCM Contractor is much lower than is usually the case under fixed time and cost arrangements. It is often limited to the re-performance of defective services and capped out at between 5-20% of the total EPCM remuneration (or, more recently, to the value of the profit and sometimes the overhead component as well). There are generally a number of carve-outs from such a limitation, including for losses resulting from fraud or wilful misconduct. Obviously, these arrangements depend on a number of factors and vary widely from project to project. Model 1: EPCM Contractor has direct contractual relationship with works package Contractors and suppliers. Model 2: EPCM Contractor procures the entry by the Owner into a direct contractual relationship for the main works package. EPCM Contracts: Project delivery through engineering, procurement and construction management contracts PwC 221 Appendix 1 to this paper contains a table summary of some key issues for the appointment of an EPCM Contractor to be considered by Owners when preparing the EPCM Contract. Typical phases of an EPCM Arrangement Design and engineering It is not unusual to have the engineering arrangements split into a number of components. The EPCM Contractor’s engagement may start as early as the feasibility stage of the project. That is, it may be engaged to analyse high level technical aspects and prepare a report on the likely timing and cost, proposed procurement arrangements for long-lead items, local project considerations and other aspects of the proposed project (usually on a straight cost-plus basis). Following the feasibility study, the Contractor may be appointed to undertake the Front-End Engineering and Design (FEED) for the project. Broadly, the FEED phase covers the basic engineering and design for the project and also the development of preliminary project schedules, budgets and work packages. This process allows the Owner to go to the market with sufficient scope definition to ensure that it receives bids which are competitive and realistic – ideally on a lump sum basis although this may only be for the procurement of long-lead critical path items (eg key equipment or foundation work/site and access preparation). As with the feasibility stage, this component usually proceeds on a cost-plus basis. Following the FEED stage, the EPCM Contractor will work the basic engineering and design into the complete detailed engineering package. In many cases, the EPCM Contractor will ultimately be responsible for ensuring that the engineering and design will meet the relevant performance parameters for the project. To this end, it must coordinate these works with the other parties involved to ensure that the engineering and design complies with the overall project specification and other specific requirements. Owner EPCM Contractor Main Works packages Suppliers Consultants Main Works packages Subcontractors Owner EPCM Contractor Main Works packages Suppliers Other Consultants Main Works packages Subcontractors EPCM Contracts: Project delivery through engineering, procurement and construction management contracts PwC 222 The EPCM Contract may also be structured in such a way so as to permit the Owner, in its absolute discretion, to instruct the EPCM Contractor to proceed to the next stage. For example, at the conclusion of the feasibility stage, the Owner can elect to dismiss the EPCM Contractor and engage another Contractor to undertake the FEED services regardless of whether the Contractor has properly performed the services. Also, the contract may be structured in such a way so as to have the EPCM Contractor roll into a lump sum EPC after conclusion of the FEED services and therefore taking the turnkey risk on the entire project. This process can provide the Owner with greater flexibility but will obviously depend on the needs and other constraints of each particular project. Procurement In addition to undertaking the design and engineering for the project, the EPCM Contractor is usually required to procure, on behalf of the Owner, all of the materials, equipment and construction works necessary for the proper completion of the project. To this end, the EPCM Contractor is required to establish a system or follow procedures for implementing such procurement arrangements. This may be a significant task if the project is broken down into many components and involves the EPCM Contractor preparing a suite of standard form procurement and construction contracts for the project (most EPCM Contractors will have these already), establishing a tender process suitable for the project and works to be approved by the Owner, responding to tender clarification issues, negotiating the commercial terms of all construction works packages and supply contracts and finalising each of the agreements for execution by the Owner or approved by the Owner for execution by the EPCM Contractor. Construction management Once the works have started, the EPCM Contractor assumes the role of the Owner’s “engineer” or “Employer’s representative” under the various work package and supply contracts. It manages and supervises each of these contracts. A key role for the EPCM Contractor is coordinating each of the works packages to ensure that all of the works interface as required and that delays and variation claims are minimised where possible. Usually the EPCM Contract will set out the limits on the EPCM Contractor’s authority. These limitations generally relate to instructing or agreeing variations, settling of claims, waiving any breach or default and certification of final payments. Depending on the scope of the EPCM services which, in some cases, evolves as the project proceeds, the EPCM Contractor is usually required to play an active role in monitoring and reporting during the testing and commissioning phase of the works packages. Further, they are generally required to oversee the notification and rectification arrangements during the defects liability period and also to deal with any other warranty issues. In certain cases, the EPCM Contractor is required to take an active role in the management of claims or disputes from work package Contractors. Alternatively, this role may be limited to the provision of advice regarding any disputes that arise during the course of the projects. Other issues Bankability and completion guarantees As mentioned earlier, where the project is financed through limited or non-recourse project financing, Lenders will demand a great deal of outcome certainty in terms of time and cost because their security is heavily reliant on sufficient and timely revenue from the operation phase. The borrower is usually the entity newly established to own the project and this usually precludes the use of EPCM Contracting even though the outcome may be cheaper and faster. The only circumstances (with some exceptions where there is government support or very strong client-Lender relationships or influence) where EPCM Contracting will be bankable where the Sponsor(s) provide the Lenders with a completion guarantee. That is, it offers the Lenders some form of parent company guarantee until commercial operation or a commitment to cover cost overruns and debt service obligations during a period of delay. Such a guarantee is usually for the total amount of the debt and falls away upon commercial operation. Depending on the Lenders, the project and the Owner/Contractor’s track record for delivering similar projects, the completion guarantee may be more limited and step down prior to commercial operation or as various stages of the project are completed. Conversely, they sometimes linger beyond commercial operation to cover market pricing risk depending on the type of project and output. EPCM Contracts: Project delivery through engineering, procurement and construction management contracts PwC 223 Incentivising the EPCM Contractor KPI and incentive arrangements are very much project-specific. As such, it is difficult to meaningfully suggest project-specific KPI arrangements without first understanding the key commercial considerations driving any particular project. These are usually a combination of time, cost, quality, safety, environment and community. To a certain extent, the corporate philosophy of the Contractor is also important. Appendix 2 to this paper contains a table summary of various KPIs and related incentive arrangements that may be relevant to the appointment of an EPCM Contractor. Whilst this table is not an exhaustive list, it includes key issues which an Owner should consider in order to encourage the behaviour it requires the EPCM Contractor to display so as to achieve the Owner’s objective for its project. Given the cost-reimbursable nature of most EPCM Contracts, an alignment of interests is obviously extremely desirable from the Owner’s perspective to encourage productive behaviour and positive outcomes. However market forces and an environment of rising costs and scarce technical resources have been driving some Contractors’ lack of enthusiasm to place too much at risk. At the early stages of a project, lack of project-definition also complicates the setting of meaningful and precise targets against which performance can be measured and appropriate behaviour encouraged. Setting the framework and principles at an early stage, while there is a competitive environment and balanced bargaining position, is generally the best way for the Owner to lock in KPI arrangements. As noted earlier, there has been a significant shift in the construction market over the last few years particularly regarding traditional risk allocation. This has also impacted the form of EPCM Contracts being used. Interestingly, some Contractors are preferring to move away from, or limit the extent and impact of, KPIs. This is largely because they believe these arrangements can:  create uncertainty (and therefore increased risk and are more difficult to achieve in a rising cost market)  cause additional friction between the parties which does not foster a sense of cooperation or trust or help develop a long-term multi-project relationship  waste time and resources on trying to monitor, document and agree on whether KPIs have been met (which detracts from the main objective of successfully completing the project). Some Owners prefer an integrated approach toward administering and managing the project akin to assuming part of, and sharing, the EPCM responsibilities. Given the magnitude, complexity and duration of the “mega projects”, some Contractors may be unwilling to commit a material percentage of their remuneration to an incentive regime structured on a “whole of project” basis as opposed to one that corresponds with discrete phases of work. Many projects are almost completely “schedule” driven. Consequently, and despite both parties’ best efforts, an incentive arrangement that predominantly focuses on time may inevitably create inefficiencies which results in increased cost, double handling and/or re-work which also puts pressure on costs. Any KPI arrangement adopted for a particular project must encourage the kind of behaviour the Owner wants the Contractor to display so as to achieve the project’s objectives. Above all, any KPI arrangement should focus on maximising productivity and delivering timely and innovative results while striking a balance between time and budget without sacrificing quality or safety or creating inefficiencies. Obviously this is easier said than done. Cost definition Where the cost-plus model is used, there needs to be a detailed assessment of what costs are in and which are not. Some EPCM models also separate the direct costs from project and head office overheads and either treat them differently or agree a lump sum or fixed percentage for some or all of the overhead or profit component. Doing so can also tie into the incentivisation regime. If fixed, then the Contractor’s margin diminishes the longer the delivery period and/or the greater the reimbursable component becomes. Alliancing comparisons The integrated team approach of EPCM Contracting is verging on an alliancing style contract without taking the final step of openly creating a “no blame” environment. The reality is however, that it becomes increasingly EPCM Contracts: Project delivery through engineering, procurement and construction management contracts PwC 224 difficult to apportion blame and pursue a Contractor for breach of contract in an integrated team approach where representatives of the Owner and the Contractor work together and make decisions jointly. Conversely, many EPCM Contracts are more similar in style to consultancy contracts and cannot be compared to alliancing. Conclusion Current projections indicate that the international construction boom is likely to continue into the foreseeable future. Consequently, more Owners and Contractors will seek to redefine traditional project delivery methods, particularly in response to a variety of economic and market-driven changes. In such an environment, it is likely that rigid fixed time and cost arrangements will become less common and we will see more of cost-plus, alliancing and EPCM arrangements. As the complexity of so called “mega projects” increases and labour, materials and professional resources become more difficult or expensive to source, Owners will need to choose between paying an increasing EPC profit/risk premium or placing greater reliance on the expertise and skill of reputable and experienced Contractors to manage the delivery of their projects. If the latter is the preferred option, a carefully planned EPCM Contract, with appropriate incentivisation arrangements, will go some way to ensuring that the Owner’s commercial and other project objectives are achieved. PwC 225 Appendix 1 xxx Issue Comment Form In its simplest form, an EPCM Contract is a consultancy agreement for the provision of professional and/or technical services. At one end of the spectrum, an EPCM Contract could be considered to be a pure consultancy-type arrangement and, at the other end, it could look more akin to an integrated alliance style contract where the parties ‟ interests are aligned through the KPI incentive regime.” There are many important factors arising out of a project and the current market which will influence the form of the EPCM Contract. They include:  the surge in demand in the engineering/project management sector across Australia and internationally  the size, complexity and profile of the project  whether the project is to be delivered on a fast-track schedule  the requirements and approach to allocation of risk of the project Sponsor(s)/Owner’s parent company(s)  the requirements of the Lenders where the project is to be financed on a limited or nonrecourse basis  the requirements of other stakeholders including governments  the extent of engineering and design already undertaken by the Owner under separate contracts (if any). Scope of services The EPCM Contractor’s scope of services typically includes:  engineering and design  procurement  construction management and administration  the provision of systems and computer software. Design and Engineering It is not unusual to have the engineering arrangements split into a number of components. The EPCM Contractor’s engagement may start as early as the feasibility stage of the project. That is, it may be engaged to analyse high level technical aspects and prepare a report on the likely timing and cost, proposed procurement arrangements for long-lead items, local project considerations and other aspects of the proposed project (usually on a straight costplus basis). Following the feasibility study, the Contractor may be appointed to undertake the Front-End Engineering and Design (FEED) for the project. Broadly, the FEED phase covers the basic engineering and design for the project and also the development of preliminary project schedules, budgets and work packages. This process allows the Owner to go to the market with sufficient scope definition to ensure that it receives bids which are competitive and realistic – ideally on a lump sum basis, although this may only be for the procurement of long-lead critical path items (eg key equipment or foundation work/site and access preparation). As with the feasibility stage, this component usually proceeds on a cost-plus basis. Following the FEED stage, the EPCM Contractor will work the basic engineering and design into the complete detailed engineering package. In many cases, the EPCM Contractor will ultimately be responsible for ensuring that the engineering and design will meet the relevant performance parameters for the project. To this end, it must coordinate these works with the other parties involved to ensure that the engineering and design complies with the overall project specification and other specific requirements of the Owner. As discussed below, the EPCM Contract may also be structured in such a way so as to permit the Owner, in its absolute discretion, to instruct the EPCM Contractor to proceed to the next stage. xxx PwC 226 Issue Comment Procurement In addition to undertaking the design and engineering for the project, the EPCM Contractor is usually required to procure, on behalf of the Owner, all of the materials, equipment and construction works Contractors necessary for the proper completion of the project. To this end, the EPCM Contractor is required to establish a system or follow procedures for implementing such procurement arrangements. This may be a significant task if the project is broken down into many components and involves the EPCM Contractor preparing a suite of standard form procurement and construction contracts for the project (in conjunction with the Owner’s legal advisors), establishing a tender process suitable for the project and works to be approved by the Owner, responding to tender clarification issues, negotiating the commercial terms of all construction work packages and supply contracts and finalising each of the agreements for execution by the Owner or approved by the Owner for execution by the EPCM Contractor. Construction Management Once the works have started, the EPCM Contractor assumes the role of the Owner’s “engineer” or “Owner’s Representative” under the various work package and supply contracts. It manages and supervises each of these contracts within pre-agreed limits of authority. A key role for the EPCM Contractor is coordinating each of the work packages to ensure that all of the works interface as required and that delays and variation claims are minimised where possible. Usually the EPCM Contract will set out the limits on the EPCM Contractor’s authority. These limitations generally relate to instructing or agreeing variations, settling of claims, waiving any breach or default and certification of final payments. Depending on the scope of the EPCM services which, in some cases, evolves as the project proceeds, the EPCM Contractor is usually required to play an active role in monitoring and reporting during the testing and commissioning phase of the work packages. Further, they are generally required to oversee the notification and rectification arrangements during the defects liability period and deal with any other warranty issues. In certain cases, the EPCM Contractor is required to take an active role with the Owner’s legal advisors in the management of claims or disputes with work package Contractors. Alternatively, this role may be limited to the provision of advice regarding any disputes that arise during the course of the project. EPCM Contractors usually do not take responsibility for:  delivery of the project by certain key milestone dates  care and custody of the works (with certain exceptions for arranging security and management of safety etc.)  the project being delivered in accordance with the project budget. These obligations would be included in the construction contracts and supply agreements. Remuneration EPCM Contractors are typically remunerated on an cost-reimbursable basis, including the following components:  Fixed Fee: Pre-agreed fixed fee or % of the value for each phase of the project to cover margin and overheads  Actual Personnel Costs: Reimbursement for directly and reasonably incurred personnel costs at pre-agreed rates (fixed for the duration of the EPCM Contract where possible), with typical carve-outs for duplication of work undertaken due to defects in the services or otherwise for the EPCM Contractor’s default  Reimbursable Expenses: Reimbursement for a discrete list of reimbursable expenses, subject to the Owner’s approval prior to the expense being incurred (ie preapproved work related travel) The EPCM Contractor may also be entitled to bonuses (or subject to a reduction in payment) under agreed KPI incentive regime. xxx PwC 227 Issue Comment Bankability Where the project is to be financed through limited or non-recourse project financing, Lenders will demand a great deal of outcome certainty in terms of time and cost because their security is heavily reliant on sufficient and timely revenue from the operation phase. In these circumstances, to provide cost certainty for the EPCM Contract, the Owner should consider capping individual incentive arrangements (or the aggregate of all) at a certain % of the fee or the estimated target costs. The Owner should also consider incorporating a guaranteed maximum or “ceiling price” cap on the EPCM Contractor’s remuneration (ie if the target man-hour budget is exceeded, the payments otherwise due to the EPCM Contractor could be deemed not reimbursable). This could apply to price caps for each phase of the project. Obviously this approach would require a certain level of project definition to enable the development of realistic target man-hour budgets during negotiations with the successful Contractor. However, the extent to which the Owner can impose a cap on the EPCM Contractor’s remuneration will depend on market conditions at the time of going to tender. In the current market we are seeing this approach rejected by many Contractors because there are opportunities to procure work on a pure cost reimbursable basis, particularly on projects that are not subject to Lender requirements/restrictions. Also, where the borrower is an entity newly established to deliver, own and operate the project, this usually restricts the use of EPCM Contracting even though the outcome may be cheaper and faster (with some exceptions where there is government support or very strong client-Lender relationships or influence). Where EPCM Contracting is used, it is not uncommon for Lenders to require the Sponsor(s) to provide them with a completion guarantee. That is, the Sponsor(s) offers the Lenders some form of parent company guarantee until practical completion/commercial operation or a commitment to cover cost overruns and debt service obligations during a period of delay. Such a guarantee is usually for the total amount of the debt and falls away upon practical completion/commercial operation. Depending on the Lenders, the project and the Owner/Contractor’s track record for delivering similar projects, the completion guarantee may be more limited and step down prior to practical/commercial operation or as various stages of the project are completed. Conversely, they sometimes linger beyond commercial operation to cover market pricing risk depending on the type of project and output. Novation of existing design Where a major proportion of the engineering and design for the project has already been undertaken under separate design/consultancy packages let by the Owner (ie FEED during the project feasibility phase), the Owner must avoid potential gaps in liability by creating a single point of responsibility for the performance of the design of the project through the novation of the existing design to the EPCM Contractor. The Owner must allow sufficient time in the project schedule for the EPCM Contractor verify and accept responsibility for the existing design. Optional Phases In most instances the EPCM Contract should be structured in such a way so as to permit the Owner, in its absolute discretion, to instruct the EPCM Contractor to proceed to the next stage. For example, at the conclusion of the feasibility stage, the Owner can elect to dismiss the EPCM Contractor and engage another Contractor to undertake the FEED services regardless of whether the Contractor has properly performed the services. Similarly, where the project is to be financed through limited or non-recourse project financing, the Owner must be entitled to terminate the EPCM Contractor in its absolute discretion if the Lenders do not give finance approval or the Owners cannot raise the required capital. Terms establishing the process, consequences (including payment on termination outlined above) and risk in the services undertaken during a particular phase will need to be clearly articulated in the EPCM Contract. Also, for certain types of projects (ie the construction of a facility such as a power station or a process plant) the EPCM Contract may be structured in such a way so as to have the EPCM Contractor roll into a lump sum EPC after conclusion of the FEED services, therefore taking the turnkey risk on the entire project. This process can provide the Owner with a single point of responsibility for design and construction and greater flexibility but will xxx PwC 228 Issue Comment obviously depend on the needs and other constraints of each particular project, including market considerations. For example, rolling an EPCM into a single EPC is unlikely to be suitable on major projects such as integrated mine, port and rail projects where the size, complexity and varying nature of the project components cannot be delivered in its entirety by one EPC Contractor or without significant risk premiums that increase costs to a level that impact on the overall viability of the project. Insurance Obviously the whole of project insurance strategy is a critical issue for all projects. It will also impact on the EPCM Contract and extent of insurances to be procured and maintained by the EPCM Contractor. For example, a project wide PI policy may be required to supplement the PI insurance provided by the EPCM Contractor, to avoid gaps in design liability in circumstances where the limit of indemnity provided under the EPCM Contractor’s PI insurance is not sufficient to cover the potential loss. Liability Caps In the current market, any sophisticated Contractor will require an overall cap on liability and exclusion of liability for consequential loss. The overall limitation could be managed in a number of ways – for example, the EPCM Contractor’s exposure could be limited to:  100% of any incentive payment or the component of the price representing the Contractor’s profit and/or overhead (or part thereof)  a percentage of the contract price – ideally, this would be the higher of the “total estimated contract price” or the actual amount of payments made to the EPCM Contractor (to overcome the issue where the EPCM Contract is terminated for breach in the early stages of the project and payments made to the Contractor are insignificant in comparison to the loss suffered by the Owner). Ordinarily, the maximum liability of the EPCM Contractor is much lower than is usually the case under fixed time and cost arrangements. In the current market, and for similar services, overall caps are reported to be typically in the range of 5% – 20% of the total EPCM remuneration (or, more recently, to the value of the profit and sometimes the overhead component as well). This is in addition to proceeds available from project insurance policies. Obviously it is desirable for the Owner to set the cap at the “high water mark” to satisfy requirements of the SponsorSponsors and Lenders in seeking to minimise gaps in liability and then by transferring liability to Contractors, suppliers and the insurers. These overall caps and exclusion of consequential loss usually do not apply to certain exempt liabilities such as the cost of re-performing defective works, infringement of IP/confidentiality obligations, third party claims, fraud, gross negligence (this is often controversial), wilful misconduct, unlawful acts and liabilities which the EPCM Contractor cannot lawfully contract out of (generally contracts are silent on this – the main one being section 52 of the Trade Practices Act). Having said that, there may be some significant push back by EPCM Contractors on these carve-outs and even limiting consequences of breach largely to re-performance of defective work (more so in an integrated team environment and after considerable debate over what is, or is not, “defective” work). Variations Owners need to develop mechanisms for determining what amounts to a variation (ie a major change to the services not contemplated by the parties) and the corresponding cost consequences (ie adjustment to fixed fee and overhead component or payment of direct costs only). This area becomes more important in relation to the achievement of KPIs and whether the target costs and time frames are to be adjusted. Pre-award workshops are often conducted with Contractors to define the limited nature of events giving rise to a variation. Termination Payments In the current market, where the EPCM Contract is terminated for the Owner’s convenience or default during one of the optional phases, the EPCM Contractor is likely to expect to be paid a portion of loss of profit for the balance of that phase and for its reasonable demobilisation expenses which have not been recovered through payment up to the date of termination. Where this is the case, to the extent possible, it is desirable to have pre-agreed fixed amounts. Where this is not possible, the method of calculation should be clearly defined, xxx PwC 229 Issue Comment including what’s in and what’s out, particularly in respect any demobilisation entitlement (on other projects we have seen the Owner paying significant sums for staff wages and relocation as part of demobilisation payments). Where the EPCM Contract is terminated for the EPCM Contractor’s default any payment should be limited to the services performed up to the date of termination and subject to the Owner’s right to set off. Contractor’s Security At the risk of stating the obvious, given the duration of the EPCM services, the likely low caps on liability and the cost of maintaining the performance security (which will ultimately be borne by the Owner), consideration should be given to the value of the security required, rather than simply allocating an arbitrary X% of the estimated contract price. Project and Services Budgets The concept of whole of project and/or EPCM services budgets could be incorporated into the EPCM Contract terms to deal with limitations on the cost of certain services or implementation contracts etc. As outlined above, any incentive or KPI arrangement incorporated could be limited where the Owner incurs cost overruns above budgeted amounts of greater than X%. Contractor’s Key Personnel The traditional provisions regarding personnel (ie the EPMC Contractor cannot remove Key Personnel without the Owner’s prior approval) may be too inflexible. Given the market squeeze on suitably qualified personnel and resourcing, consideration could be given to alternate arrangements regarding Key Personnel – such as payment of a liquidated amount where senior personnel leave or are taken off the project within a certain period (ie within 2 years – we have seen amounts up to USD$300k for the project director). Possible exceptions to such payment could include illness, incapacitation, and resignation or if the personnel are temporarily absent on annual, sick, long service or compassionate leave etc. If liquidated damages are not suitable, Key Personnel turnover could also be a consideration in any KPI incentive payments (as outlined in Table 1). Project Control Group Generally the Owner will establish a form of “Project Directorate” or management team (Project Control Group) comprising personnel from the Owner, Sponsor(s) and the EPCM Contractor. Terms must be included dealing with the composition, role and powers of the Project Control Group (and various other administrative matters, such as meeting protocols and reporting). These arrangements could also deal with the Owner’s “reserve powers”, the flexibility to add other equity participants to the Project Control Group and procedures for determining KPI performance as discussed above. Health and Safety The Owner must consider that it will have primary responsibility for implementing the workplace, health and safety obligations for the project. We often see the EPCM Contractor (to the extent permitted by law) assuming primary responsibility for implementing the workplace, health and safety obligations for the services and the overall project (including any and all implementation Contractors and the Owner’s personnel at the site). Disputes Given the likely duration of the EPCM Contract, the fact that small disputes are likely to occur and a good working relationship must be maintained at the senior project level, it may be beneficial (in terms of certainty and time) for the EPCM Contract to establish a dispute resolution procedure in advance of any arbitration or litigation. For example, negotiation between the parties’ representatives; escalation to negotiation by senior representatives not heavily involved in the project (or the Project Control Group); referral to expert determination (or other form of resolution); and then to arbitration or the courts. From an enforceability perspective, arbitration is preferred if contracting with foreign parties (ie to be able to rely on the New York Convention). Reserve Powers Terms should be added to clarify the “reserve powers” held by the Owner to manage and direct the project, including approval of systems and procedures governing the project, urgent protection of people and property, issuing bid documents, awarding implementation contracts, approving variations and extensions of time or any event likely to have a major impact on the operation or viability of the project etc. xxx PwC 230 Issue Comment Lender requirements Where the project is to be financed through limited or non-recourse project financing, terms must be added to the EPCM Contract regarding the usual Lender requirements (such as step-in rights, cooperation (including providing access to Financiers’ engineer), execution of a tripartite deed, the Owner’s right to assign its interest in the EPCM Contract etc). PwC 231 Appendix 2 xxx Incentive Arrangement Comment General Given the cost reimbursable nature of EPCM Contracts, without KPI incentive mechanisms, it is difficult, if not impossible, to instil the same sense of urgency and efficiency in the EPCM Contractor and its personnel over a long period as compared to a fixed price model. Therefore, the KPIs will be critical in incentivising the EPCM Contractor to perform in a safe, productive, efficient and timely manner in order to ensure the Owner’s key commercial objectives for the project are realised – usually time, cost, quality, safety, environment and community or some combination of these. It is critical to the success of the KPI incentive regime that, when formulating the targets and methods of measuring performance, there is sufficient clarity of project scope and the Owner’s requirements. Whenever possible, the Owner must allow sufficient time and resources to agree and clearly articulate quantifiable KPI targets and corresponding methods of measuring performance in the EPCM Contract. Obviously, formulating incentive arrangements is problematic where they need to be agreed through the execution phase. This approach is not recommended as the parties often fail to reach agreement, in which case the incentive regime has little or no value. The KPI incentive regime should focus on maximising productivity and timely delivery whilst striking a balance between time and budget, and without sacrificing quality or safety. We have seen very detailed and sophisticated KPI incentive regimes, particularly in an alliancing or relationship contracting context and where project deliverables are to be measured over long time frames. Conversely, some EPCM Contractors prefer to move away from (or limit the extent and impact of) KPI incentive regimes, largely because they believe these arrangements can create uncertainty (and therefore some risks in a rising cost market) and additional friction between the parties, which does not foster a sense of co-operation or trust. Where this is the case, we see Owners often opting for an integrated approach toward administering and managing the project (akin to assuming part of, and sharing, the EPCM responsibilities). In the current market we are also seeing that some EPCM Contractors are unwilling to put a material percentage of their remuneration at risk based on a KPI incentive regime. However, if the KPI incentive regime is structured with proper recognition of the current market conditions and the issues below are addressed then successful outcomes are achievable. KPI – Cost The cost incentive arrangements can be structured on a “whole of project basis” or a “phase by phase” basis with an underlying “whole of project” component (which directs the EPCM Contractor to also focus on the integration of the phases into the over-arching project). For the “whole of project” component there needs to be a meaningful target reimbursable cost – something that might not be available with any degree of accuracy at the time the Owner elects to go to the market. The Owner should consider whether it has sufficient detail to develop realistic target manhour budgets. If the target man-hour budget is exceeded, certain components of the payments otherwise due to the EPCM Contractor could be deemed not reimbursable (unlikely to be acceptable in this market), or there could be some reduction in the incentive payment (likely to be more acceptable). Another alternative is to set a fixed profit and off-site overhead component as part of the EPCM Contractor’s remuneration. If the project takes longer than anticipated or more man-hours are required, the profit and overhead component does not change. It diminishes as a percentage of the overall project value (unless there is a very significant/fundamental change in scope). xxx PwC 232 Incentive Arrangement Comment KPI – Schedule The traditional schedule disincentive arrangements of liquidated damages for delays are not generally applicable in the EPCM context. This is because the EPCM Contractor does not have complete control over the delivery of the works and achieving project milestones. On projects where time is of critical importance, the “carrot” rather than the “stick” approach seems more commonly used. This can be done by agreeing fixed bonuses up front (typically where the additional revenue/cost savings to the Owner resulting from early completion can be assessed at the outset), or by including schedule KPIs as part of an overall weighted performance measurement calculation used to determine bonuses or abatements. As noted above, schedule incentive can also be dealt with indirectly, by setting a fixed profit and off-site overhead component (ie if the project takes longer than anticipated, the profit and overhead component diminishes as a percentage of the overall project value). Many projects are almost completely “schedule driven.” Despite both parties ‟ best efforts, any arrangement that predominantly focuses on time may inevitably create inefficiencies (resulting in increased cost, double handling and/or re-work which ultimately puts pressure on costs and impacts on quality and safety). Therefore, it is important to try, if possible, to ensure that the KPI incentive regime is not solely “schedule” driven to eliminate those inefficiencies. Obviously, too great an emphasis on schedule incentive arrangements can jeopardise or undermine other objectives of the project – ie cost, safety, quality, environmental performance, community relations and minimising operational expenditure. KPI – Performance There are many other ways in which to incentivise Contractors regarding performance. It is not unusual to see performance incentive arrangements where performance by the EPCM Contractor which:  exceeds pre-agreed fixed targets will lead to better than normal returns for the EPCM Contractor  falls short of the pre-agreed fixed targets will lead to poorer than normal returns for the EPCM Contractor. It is important to set targets that can be effectively measured to collect demonstrable performance information. This is easier said than done and requires specific project management expertise. If this is not possible, or it is difficult, there is a real prospect of dispute and the incentive arrangement will be of little value. Regular meetings of a “Project Control Group” (made up of members from both the Owner and the EPCM Contractor) where performance issues are raised and areas for improvement are identified are important (as are outcomes and objectives reached during any pre-contract workshops to set targets). It is also common to see KPI incentive mechanisms whereby the Contractor’s overall bonus (or reduction in fee) is determined using weighted performance measurement across several preagreed targets (ie time, cost, safety, environment and community). The weightings and formula are agreed and recorded in the EPCM Contract from the outset. The weightings reflect the importance placed on each target in achieving the Owner’s commercial and other objectives for the project (it is common to see safety with the greatest weighting). Often it is the role of a Project Control Group to analyse performance against targets and determine the inputs to the formulae used to determine the adjustment to the Contractor’s fee (if any). To avoid disputes over performance it is important that the measurement of performance is based on quantifiable targets and not open to subjective interpretation. However, in circumstances where the Project Control Group is unable to reach agreement on performance, the determination is typically made by the Owner’s representative or an independent expert (the latter generally considered the fairer option, while recognising that appointment of the expert will be an additional cost to the parties). Under a weighted performance mechanism, the Contractor may be entitled to a bonus, despite failing to achieve one of the KPI targets. Alternatively, the EPCM Contractor’s bonus or the fee payable may be reduced where the EPCM Contractor achieves some but not all of the targets. xxx PwC 233 Incentive Arrangement Comment KPI – Safety Generally, KPI arrangements for safety are largely based on the corporate policy of the Owner or the project SponsorSponsors (ie zero deaths and/or lost time injuries (LTIs)), many of which are absolute. Other factors that may be relevant include:  compliance with safety management plans, procedures and policies (and diligence in reporting and/or ensuring other parties comply with these)  number of accidents, near misses or project-related injuries  Contractor’s management and administration of accidents, near misses and projectrelated injuries (ie reporting, preparation of hazard assessments etc). It is likely that many of the safety incentive arrangements for the EPCM Contract will also take into account the performance of the other Contractors appointed by the Owner on the project. This is typically the case where the Owner wants the EPCM Contractor to drive safety KPIs and culture across the whole project. Also, it is not uncommon to see the achievement of certain safety KPIs as a mandatory requirement to the EPCM Contractor receiving any incentive bonus. In these circumstances, where the Contractor fails to achieve these KPIs, they often forfeit the entire project incentive arrangement (not just for safety) that would have otherwise been available to them. For example where there is a major personal injury suffered by a person involved with the project, which results in permanent disability or death. However, the mandatory requirement to the incentive bonus may not be appropriate in the context of a single or several LTIs, particularly where the EPCM services are to be performed over 1 to 3 years. This is because it is likely that the EPCM Contractor (or one of the Owner’s other Contractors) will suffer an LTI at some stage during this period, which would render the whole incentive regime void. Obviously, the Owner should also consider the corporate policy of the Sponsor(s)/Owner’s parent company(s) in setting safety KPIs for the EPCM Contract. KPI – Quality Quality incentive arrangements are not always afforded a great deal of attention in many KPI arrangements (generally at the expense of time and cost issues). It is important to ensure that the end product is of the specified quality to minimise impact on the long term operational expenditure and profitability of the project. Generally, it will be the EPCM Contractor’s responsibility to identify and instruct the Owner’s other Contractors when certain performance or quality guarantees are not being met under the various work packages. Factors that may be integral in any assessment of the EPCM Contractor’s quality performance include:  instances of defective services, equipment, systems or re-work by the EPCM Contractor  failure to meet the Owner’s performance and other design requirements on, and after, commissioning  failure to identify defective work, equipment or plant of other Contractors and suppliers  functionality, throughput, availability and reliability of the supply chain; compliance with quality management plans, including conduct of audits and inspections (and diligence in ensuring other parties comply with these)  failure to meet reporting obligations  failure to properly administer contracts on behalf of the Owner  poor communications or responsiveness  failure to comply with relevant project approvals, regulations and standards. Back to back obligations would also be included in the implementation phase construction contracts and supply agreements. xxx PwC 234 Incentive Arrangement Comment KPI – Environmental and Community Impacts A project’s impact on the environment and community are often of key concern to the Owner and other stakeholders. Certain KPIs can encourage the EPCM Contractor to ensure it, and the Owner’s other Contractors, diligently comply with their environmental obligations and meet the project’s environmental objectives. Factors we have seen that may influence any environmental and community incentives include:  quality and timing of responses to environmental and other complaints from the community and stakeholders  where relevant, management of community (including Indigenous) consultation and education  number of incidents of environmental harm and the timing and quality of the corresponding response to such incidents  compliance with environmental management plans (and diligence in ensuring other parties comply with same)  compliance with the conditions and reporting requirements under any statutory approval  establishment of effective administrative procedures to deal with notifications under any implementation phase construction contract or supply agreement. KPI – Key Personnel Given the current pressure in the market on retaining skilled and appropriately experienced personnel, securing and retaining quality personnel for any project will be critical. Retention of sufficient numbers and key personnel has been an issue that commonly arises (especially where the project spans many years) and often results in negative cost and time outcomes due to a lack of resources and continuity of key people. Approaches to key personnel KPIs that may be considered include a reduction in the EPCM Contractor’s fee:  for high turnover rate of personnel (outside of pre-agreed parameters)  for replacement of personnel during a “project introduction phase” (based on discounted rates)  for the number of personnel removed as a result of incompetence, negligence etc. The Owner may also consider some form of direct bonus for the retention of individual key personnel over certain timeframes or the life of the project or the reimbursement of recruitment costs. Some EPCM Contracts also include payment of liquidated damages by the EPCM Contractor where senior personnel leave or are taken off the project within a certain period. Assessment There are many ways that KPIs can be assessed including:  through the use of a formula or other mutually agreed procedure whereby the Contractor’s performance is evaluated against set criteria. This is often a detailed schedule to the EPCM Contract that sets out where the risk and reward lies  through a procedure to be agreed by the parties after the EPCM Contract is signed (although as outlined above we do not recommend that you adopt this approach)  use of a committee to agree the measurement of KPIs with a dead lock or dispute resolution mechanism. As discussed above, it is important that the assessment of performance is based on quantifiable targets and not open to subjective interpretation. xxx PwC 235 Incentive Arrangement Comment Structure The Owner should consider how KPIs are going to be structured, such as:  a percentage of the EPCM Contractor’s profit  a percentage of other amounts payable under the EPCM Contract (for example, profit and overhead but not direct costs)  a bonus pool or discrete cash amount set up only for the calculation of KPIs and independent of the payment provisions under the EPCM Contract. Timing There are a number of alternatives regarding the timing of any incentive payment:  a one off “bullet” payment at the end of the project  payments to be made at the end of each discrete phase with an additional “whole of project” payment or fee reduction made at the end of the project  payments offered on a calendar or financial year basis (to coincide with the Owner’s reporting or other project obligations)  certain incentive payments could be contingent upon the happening of a set event (ie timely delivery of key materials, return of performance security etc)  a combination of the above. Other Considerations The Owner may also want to consider the following:  whether each incentive arrangement (or the aggregate or all) will be capped (for example, at a certain % of the fee or the target costs), particularly where the project is financed through limited or non-recourse project financing because Lenders will demand a great deal of outcome certainty in terms of time. This can be for both individual and overall KPIs  how often the incentive arrangements will be assessed and the relevant processes that must be followed  how often the incentive arrangements will be paid or deducted. This is particularly important as some KPIs can only be assessed after completion of the project  whether the incentive arrangements can be challenged and, if so, how this is done. For example, the parties could agree to establish a Senior Management Group made up of senior executives of the Owner and the EPCM Contractor to review and attempt to agree upon any disputed decisions in relation to incentive payments prior to litigation or arbitration. Alternatively the EPCM Contract could provide for independent determinations of such disputes  whether there is a mechanism to vary any of the incentive arrangements to account for the changing emphasis and priorities of the project and drive preferred Contractor behaviour. Such a mechanism could also be used to address incentive arrangements that are not working as anticipated or those that have become less relevant. It could also address the timing of payment, amount of payment, method of calculation, criteria, addition of other incentive arrangements etc. PwC 236 9 Splitting an EPC Contract The hidden dangers of split EPC Contracts One innovation that is becoming more prevalent in infrastructure project financing in Asia involves an extension of the traditional project documentation structure whereby the works under an Engineering Construction and Procurement (EPC) Contract are divided or “split” into two or more separate contracts. The split structure offers reduced taxation obligations on the Contractor by allowing the Contractor to avoid local taxes on equipment and materials purchased from “offshore”. The savings result in a reduced project capital cost, which in turn may be passed onto the Project Company and its Lenders. The concept of splitting EPC Contracts Under the classic split, the EPC Contract is divided into two separate contracts, commonly referred to as the “onshore contract” and the “offshore contract”. The responsibilities of the offshore Contractor will usually be restricted to:  the supply of design and engineering services  the supply of plant, equipment and materials (equipment) sourced from outside the host country. The responsibilities of the onshore Contractor will usually be restricted to:  the installation of equipment sourced from outside the host country and procured under the offshore contract, once the equipment has reached its onshore destination  the construction, testing, commissioning and other onsite activities (including some onshore design and engineering services) associated with the works  the supply of equipment sourced from within the host country. It will also be necessary to consider the splitting of obligations to provide training and supply spare parts. To complete the split structure, an agreement is required to coordinate and wrap the obligations of the onshore and offshore Contractors to the Project Company. This way, any gaps that arise as a result of the split structure are appropriately covered and the Project Company’s recourse, in the event of a failure in the performance of either the onshore Contractor or the offshore Contractor, will only be to a single entity – The Guarantor (as would have been the case in the traditional EPC Contract form). In some structures the offshore Contractor will also be the Guarantor. Why split EPC Contracts? In a word: tax. The split structure is designed to avoid or reduce the profit element of any equipment supplied from outside the host country, or any design work performed outside the host country, becoming subject to local taxes. The classes of taxes, both direct and indirect, that an EPC Contractor and a Project Company may be exposed in the host country include value added taxes; withholding taxes; technology transfer taxes; import and stamp duties; local construction and property license fees and duties; and onshore income or profits tax. Other commercial considerations may drive the split structure, such as avoidance of local “red tape” requirements and costs associated with obtaining permits, approvals and submitting designs to local government authorities in the host country. Caveat on splitting EPC Contracts Splitting EPC Contracts will not be appropriate for every project. Appropriate local taxation advice and legal advice should always be sought before deciding whether to split the EPC Contract into two or more contracts to take advantage of taxation savings and other commercial benefits. Different legal and tax jurisdictions will have their own specific requirements which will impact on the structure. For example, in some jurisdictions a mere Splitting an EPC Contract PwC 237 reference in the onshore contract to the offshore contract (or vice-versa) may defeat the tax advantages that the split structure is intended to achieve. The legal issues associated with splitting EPC Contracts Specifications: Where two separate specifications are prepared, the Project Company should thoroughly review the specifications to ensure that there are no inconsistencies and that when combined, they cover the entire works. Any “gaps” produced as a result in splitting the specification should be covered in the umbrella agreement. If one specification is adopted to cover the whole of the works, then it should be made clear that the offshore Contractor’s scope of work includes all activities associated with the supply of design and engineering services and the supply of equipment sourced from outside the host country. The onshore Contractor’s scope of work will include all remaining activities necessary for the proper completion of the works. Timing and performance issues: Where the split structure results in split liquidated damages and extension of time regimes, the Project Company will need to scrutinise the regimes in each contract to ensure they are consistent and interact logically and correctly. Quality issues: The Project Company should ensure that the overall design obligations are assumed by one Contractor, usually the onshore Contractor which has established a presence in the host country. The Guarantor under the umbrella agreement should then provide a guarantee for the Contractors’ design obligations. Coordination issues: The onshore contract should provide that the onshore Contractor is responsible for all equipment sourced from offshore from the moment the offshore Contractor ceases to be responsible for that same equipment and in the same way that the offshore Contractor is responsible under the offshore contract for the equipment. Residual legal issues: The Project Company should also address the following issues with a split structure:  caps on liability and liquidated damages  termination and suspension  variations/change orders  confidentiality issues  governing law  Force majeureforce majeure. The umbrella agreement In terms of providing the necessary legal protection to the Project Company, the most important document is the umbrella agreement (also known as a “wrap around guarantee agreement”, “coordination and administration agreement”, “supplemental agreement” or “guarantee agreement”). The umbrella agreement will, if properly drafted, provide the Project Company with a single point of responsibility and more importantly, prevent the various Contractors from relying on each other’s defaults to avoid performing their contractual obligations – a tactic known as a “horizontal defence”. The umbrella agreement should also prevent a Contractor from relying on the Project Company’s default where the Project Company’s only default was a result, either directly or indirectly, of the non-performance, inadequate performance or delay in performance of any of the other Contractors under their respective contract. In addition to horizontal defences, the umbrella agreement should deal with the following matters:  guarantees and indemnities  liquidated damages  the performance bond by the Guarantor’s parent  liability (and limitation of liability) of the Guarantor Splitting an EPC Contract PwC 238  duration of the umbrella agreement  dispute resolution – it should be identical to the project documents and allow the Project Company to consolidate claims. Conclusion The splitting of works between two or more contracts is usually driven by tax and other commercial considerations. Provided appropriate taxation and legal advice is sought and received, and it should be in every case, and provided all associated legal issues are adequately addressed in the split contracts and co-ordinated and “wrapped” in the umbrella agreement, the taxation and other commercial benefits offered under the split structure should flow through to the Project Company and its Lenders. PwC 239 10 Preparing the Employer’s Requirements for a Construction Project Introduction The Employer’s requirements are project-specific components of the construction contract that document the:  fitness for purpose criteria for the project  Contractor’s scope of work and design and how it is to fulfil those obligations  technical criteria to be satisfied  other project-specific obligations Preparing and putting into words the Employer’s requirements for a construction project is one of the most difficult tasks the Employer will undertake and is critical to the success of the project. It requires market research, a thorough analysis of the many commercial and legal influences and risks on the project, and expert technical and project management skills. Importantly, it also requires the Employer to have a clear understanding of the project purpose, goals and objectives from the outset of the contract procurement process. Unfortunately, Employers often select a contract delivery method for a project and commence preparing the contract documents without identifying their goals and objectives at an early stage so that those responsible for developing the contract documents do not have a clear understanding of what the Employer wants from the final product. It is also not uncommon for lawyers acting for an Employer to prepare the general conditions in isolation from the Employer’s technical consultants responsible for the Employer’s requirements and other technical documents. This leads to inconsistencies between the various components of the construction contract and uncertainty as to the extent of the Contractor’s obligations. It also increases the risk of important aspects of the Contractor’s obligations not being comprehensively described in either the general conditions or the Employer’s requirements and leads to a misalignment of the parties’ expectations, which is a common cause of disputes and costly variations. To avoid these risks, the process should be centrally managed by suitably qualified personnel with combined expertise in contract procurement, contract administration, project delivery and legal drafting. Key stages in preparing the Employer’s requirements There is no universally accepted process for preparing the Employer’s requirements. The process will vary depending on the Employer’s resources, commercial drivers and the nature of the project. However, irrespective of these variations, the guiding principles for an Employer when preparing the Employer’s requirements and other contract documents must be to:  allocate sufficient time and resources to conduct market research, gather information and identify its overall requirements for the project  document the project goals, objectives and purpose at the outset, so that those responsible for developing the contract documents have a clear understanding of what the Employer wants from the final product and what it expects the Contractor to deliver Preparing the Employer’s Requirements for a Construction Project PwC 240  document the Employer’s requirements in a manner so that it articulates precisely and consistently what must be designed and/or constructed by the Contractor and who will be responsible for design and other prior works (if any) undertaken by the Employer  undertake a global review of the contract documents, utilising the combined knowledge of the Employer’s project management team, expert technical consultants and lawyers to ensure consistent and clear drafting throughout the contract and certainty in relation to the project goals, objectives and purpose. In practice, the Employer’s requirements will evolve in stages and will vary for different types of projects. To outline the key stages, we have chosen the design and build contract (D&B Contract) project delivery method. This is a useful basis for discussion because the Employer has to prepare Employer’s requirements for design consultants responsible for the concept and preliminary design (Design Consultants) and ultimately for a design and build Contractor (D&B Contractor). The key stages in developing the Employer’s requirements for a D&B Contract are: Each stage of this process will be described in further detail below. STAGE 1 Establish the Employer’s project goals and objectives and document the purpose of the project STAGE 2 Document a detailed project plan setting out the Employer’s time, budget, resource and quality related requirements STAGE 3 Select the method of project delivery (for present purposes the D&B Contract) STAGE 4 Prepare a design brief (“Design Brief”) for the Design Consultants, which describes the purpose of the project and services to be performed STAGE 5 Prepare the Employer’s Requirements for the D&B Contract, including a project brief that describes the purpose of project and final design and construction works to be performed by the D&B Contractor (“Project Brief”) STAGE 6 Conduct a global review of the General Conditions and the Employer’s Requirements Preparing the Employer’s Requirements for a Construction Project PwC 241 Stage 1 – Establishing the project goals, objectives and purpose of the project Prior to choosing the contract delivery method and attempting to articulate the Employer’s requirements, the Employer must establish its goals and the purpose of the project. This forces the Employer to consider and prioritise its goals and objectives at an early stage and will ultimately form the basis of the Employer’s requirements to be included in the D&B Contract. This will include consideration of the impact the project will have on its resources and existing operations and the commercial, technical, quality and timing requirements. It does not matter if the requirements cannot be finalised at this point because these requirements will be updated as the design and planning progress. The factors that the Employer must consider at this early stage include:  the overall timing of the project, including understanding the Employer’s current business market, where the market will be when the Employer intends to sell the product generated by the project and at what point in the boom/bust cycle the construction industry is at the time of the project  the specific timing requirements, including the critical stages and milestones for the project and when are they required to be completed  budgetary restrictions and the Employer’s economic and commercial drivers  availability of both internal and external resources required to complete the project  the external requirements of customers and other relevant parties and authorities Determining the target market and the requirements of customers and other external parties, in addition to the Employer’s internal requirements, is critical during this stage. For example, in the property development sector, the external requirements of the residential and commercial sales contracts, tenancy agreements, relevant government authorities, Financiers (if any) and arrangements with utilities and services providers will all form the basis from which the Employer’s requirements must be developed. Analysing these external agreements and requirements is critical to the D&B Contract procurement process because they contain concessions which have been made by the Employer and which oblige the Employer to ensure that the project is designed and constructed in order to fulfil certain requirements. This will directly affect the D&B Contract and the Employer’s requirements. Examples include:  timing of construction  approvals for commencement of the works  labour, safety, environmental and development guidelines  access restrictions  design approval process  construction methodology  the standard and quality of materials and finishes  performance requirements and outputs (if any)  the pricing and approval of variations and extensions of time and financier step-in rights  interface requirements with utilities and service providers Preparing the Employer’s Requirements for a Construction Project PwC 242  the requirements for completion and certification. It is therefore essential that the Employer determines what its obligations are in order to meet these external requirements from the outset. It can then communicate them to those responsible for developing the contract documents and, in turn, build those specific obligations into the Employer’s requirements and ultimately pass on those obligations to the Design Consultants and the D&B Contractor as required. Stage 2 – Document a project plan Once the Employer has established its internal and external requirements, it then needs to prepare a detailed plan for the delivery of the project that articulates those requirements. The plan should include:  a clear statement of the purpose of the project  the goals and objectives, including time, cost and quality and requirements of external parties etc.  a resources plan that identifies internal resources and where external resources are required to produce the contract documentation and deliver the project  budgets  an overall development programme and milestones  any other specific requirements of the Employer Generally, it is not until the completion of this stage that the Employer will be in a position to consider the appropriate method of project delivery. Stage 3 – Selecting the method of project delivery There are numerous project delivery options for the Employer to choose from including:  design by the Employer and construction by a Contractor  preliminary design by the Employer and final design and construction by a Contractor  total design and construction by a Contractor  design by Employer, construction by trade Contractors and management of project delivery by a construction manager  design commenced by Employer – Design completion and construction by Contractor The selection of the most appropriate method (there is usually no right or wrong way to deliver the project) requires careful thought and consideration of many of the factors identified in stages 1 and 2. This paper will not attempt to provide an analysis of the various project delivery methods. However, for the purposes of illustrating stages 4 and 5 of the process, we will identify some of the issues, by no means exhaustive, to be considered by the Employer when preparing the contract documents for the project delivery method referred to in item (b) above. This is where the Employer elects to commence preliminary design using the Design Consultants engaged under separate agreements (Consultancy Agreements) before engaging the D&B Contractor to perform the final design and construction. Stages 4 and 5 below focus on developing the two key construction-related documents for this method of project delivery, which are:  the design brief for the preliminary design to be carried out by the Design Consultants (Design Brief)  the Employer’s requirements for a D&B Contract Preparing the Employer’s Requirements for a Construction Project PwC 243 Given that the scope and risk profiles will vary for each project and across construction sectors, it is not possible to provide a comprehensive list of all the issues the Employer should consider when preparing the Design Brief and the Employer’s requirements. However, the following sections will highlight some of the important issues that should be considered when preparing those documents. Again, it should be noted that regardless of the type of project or the specific risk profile, it is still essential for the Employer to clearly articulate the requirements it has developed during stages 1 to 3 in both the Design Brief and the Employer’s requirements. This must be in a manner that is consistent with the general conditions and clearly describes the obligation of the respective parties. Stage 4 – Prepare the design brief for the consultancy agreements Using the information compiled during stages 1 to 4, the Employer should prepare and include a Design Brief in the Consultancy Agreements. This is in addition to the contract documents which specify the actual scope of services and deliverables for each of the Design Consultants. It is in this Design Brief that the Employer articulates its goals and objectives, including its time, cost, quality and other requirements and how the Design Consultants are to comply with those requirements so that the Employer can measure and enforce the Design Consultant’s obligations. The Design Brief will develop as the design develops, but one must be included at the outset in all of the Consultancy Agreements. The ultimate goal in the D&B Contract project delivery method is to have the D&B Contractor assume an overall fitness for purpose obligation for the final design and construction of the project and for it to become responsible for the preliminary design prepared by the Design Consultants on execution of the D&B Contract. Therefore, it is critical that the Design Brief prepared for the Consultancy Agreements is consistent with the Employer’s requirements to be provided to the D&B Contractor. Examples of other important aspects to be considered by the Employer when preparing the contract documents which specify the actual scope of services and deliverables for each of the Consultants include:  a clear description of the deliverables, coordination and interface obligations and the timing for the provisions of the services, for each of the Design Consultants, during each phase of the design.  the design programme for the performance of the services which must be consistent with the Employer’s overall development programme and timing requirements described in stage 2 above  administrative issues such as reporting and attendance at meetings and where applicable must be consistent with the D&B Contract  a statement that each Design Consultant confirms that it understands the Employer’s goals and objectives and the Design Brief Often these obligations would be documented in the schedule of scope of services. Stage 5 – Prepare the Employer’s requirements for the D&B contract It is fundamental to the success of the project to identify precisely what must be designed and then constructed by the D&B Contractor and the performance criteria that must be satisfied. The particulars of that essential element of the procurement process must be contained in the Employer’s requirements, including the requirements of external parties identified in stages 1 and 2. The level of detail contained in the Employer’s requirements will vary depending on the timing of its preparation and the extent of design completed prior to the formation of the D&B Contract. Clearly, the later the Employer’s requirements are prepared the more detail that can be incorporated. The preparation of the Employer’s requirements during this stage is an excellent test to ascertain whether the Employer is in a position to sensibly articulate its requirements for the project. If it cannot describe its requirements with certainty in the Employer’s requirements, then logically the contract procurement process has not reached a point where the D&B Contract can sensibly be distributed to tenderers. Preparing the Employer’s Requirements for a Construction Project PwC 244 The contents of the Employer’s requirements will obviously vary depending on the nature of the project, the specific scope of work and risk profile. The information compiled during stages 1 to 4 will form the basis from which the Employer’s requirements will be further developed and finally articulated. For instance, the Design Brief referred to in stage 4 will be further developed with the assistance of the Design Consultants and form an integral component of the Employer’s requirements for the D&B Contract. Examples of key aspects to be considered by the Employer and articulated in the Employer’s requirements for any D&B Contract include:  a list of the Employer’s goals and objectives for the project. The emphasis in this regard, and at this critical stage, is on providing detailed and measurable objectives, rather than general objectives or motherhood statements  the obligations that must be satisfied by the Employer under separate arrangements with external parties that are to be passed on to the D&B Contractor must be specified in detail. These obligations will include development and planning approvals, environmental approvals, agreements for lease, sale agreements, agreements with adjacent lands and the requirements of banks and Lenders. Fundamentally, in preparing the Employer’s requirements, the Employer must ask itself whether it has procured the D&B Contractor to fulfil all of the Employer’s own relevant obligations with external parties  the Employer’s future operational expenditure. The Employer must ensure that its requirements, in terms of operational expenditure once the project is taken over by it, including future concession or off-take agreements and arrangements with service and utility providers, are also specified. This is important, not only in relation to interface obligations, but also because reduced capital expenditure through design and selection of materials, which might be a source of savings for the D&B Contractor, will often only be achieved at the expense of increased future operating expenses. These are, of course, borne by the Employer  relevant industry standards and criteria. However, considerable care must be taken before specifying a benchmark existing project or using an existing Employer’s requirements document for another project as the required standard to be achieved. It will be rare that any other project will encapsulate and be consistent with all of the Employer’s specific requirements of its project. The Employer must also consider the commercial implications of using an existing project to set a minimum benchmark. The D&B Contractor will inevitably assess the risk of uncertainty between the actual required standard and the minimum benchmark and pass this cost onto the Employer in the contract price  quality of equipment and materials. For example, in a commercial or residential building project the standard of finishes, floor coverings and sound proofing should be specified, as should the telecommunications and security requirements and ecologically sustainable development (ESD) requirements. However, particular care must be taken if the Employer intends to prescribe a product. Prescribing specific items can lead to difficulties in enforcing the D&B Contract in relation to fitness for purpose and design warranties. Rather than the Employer specifying a particular product, it may be preferable for it to describe the type, appearance and purpose of the product. The reason for this is, if the Employer prescribes a specific product and a defect is found in that product after it is installed, then it will have difficulty rejecting the product on a fitness for purpose basis. The question should be which party is to be responsible if the material or equipment ultimately does not perform as required? If the Employer wants the answer to be the D&B Contractor, then it should not tell the D&B Contractor what specific product to use. The types of description that should be avoided include sizes, thickness, strength, suppliers and models. Of course, if the Employer has a specific requirement and wishes to use a particular product and in turn take the risk of that product performing, then it must clearly set out that requirement. For a residential development project, for example, it will often be in the interests of both parties to carefully draft a mechanism in the D&B Contract providing for the construction of a prototype villa or apartment so that issues of specified finishes and design functionality can be worked through at an early point in the design and construction process.  Separable portions, milestones, program and staging requirements for the project, particularly where the development is to occur adjacent to operating buildings and/or facilities or the Employer’s external obligations dictate staged completion. Preparing the Employer’s Requirements for a Construction Project PwC 245  The scope and extent of the works to be clearly delineated. The Employer must consider whether some of the works will be carried out by others and then consider the critical issue of the interaction and interface between those parties. This is a common cause of disputes and variation claims for delay.  The scope of the D&B Contractor’s design obligations and the existing design prepared by the Design Consultants. An issue that is peculiar to this type of D&B Contract delivery method involving the novation of the Employer’s Design Consultants to the D&B Contractor is the status of the design work completed by those Design Consultants on behalf of the Employer (Existing Design). The purpose for using a D&B Contract delivery process is that the D&B Contractor is solely responsible for the final design of the project under the D&B Contract. However, a key question is what happens to the Existing Design? If the Existing Design contains elements that the Employer absolutely must have included in the final design then these elements must be transferred to the Employer’s requirements. In our view, the Existing Design should be considered as a work in progress that the D&B Contractor can develop and change as the final design development proceeds. However, to avoid disputes over design responsibility, the general conditions and Employer’s requirements must be consistent on this point. The general conditions should provide that the D&B Contractor warrants and takes responsibility for any Existing Design included in the Employer’s requirements, so that the Employer can enforce the D&B Contractor’s overall design obligations and fitness for purpose warranties. It is possible to place overall design responsibility on the D&B Contractor while still ensuring the Employer retains control of the design process by incorporating carefully drafted design review regimes. Alternatively it is also possible to prohibit any changes by the D&B Contractor to the Existing Design, but this removes a fundamental commercial benefit to the D&B Contractor to value engineer its design and make allowance in its price the cost savings it believes it can achieve by developing the design to suit its construction methods. It also potentially limits the design promises made by the D&B Contractor and must therefore be considered in that context. This balancing act between the requirements of the Employer to control the design and the commercial driver of the D&B Contractor is a very important dynamic to understand and should be foremost in the Employer’s mind when selecting the project delivery method during stage 3 and then when deciding on the level of detail to be included in the Employer’s requirements.  Design documents and maintenance manuals to be provided by the D&B Contractor, including the form of the documents.  Performance requirements for the works identified during stages 1 to 4. These are essential for a D&B Contract arrangement and they must be exhaustively specified. For example, the Employer’s requirements for the construction of a high rise building may include detailed performance requirements for air conditioning, lifts and other services, net lettable areas, environmental ratings, apartments sizes and car park numbers. These performance requirements should be carefully and thoroughly described, along with how satisfaction of those requirements will be determined. Consideration must be given to:  designing for whole of life requirements and the method of design review and approval  specific fitness for purpose requirements and a description of how satisfaction will be determined by the Employer  compliance with technical standards and specifications  performance guarantees and performance liquidated damages (if any)  the completion, testing and commissioning requirements including Employer supplied resources (both personnel and materials), responsibility for output (which can be blurred if the Employer provides resources), provision of input material (including quantity and quality) and provision for delayed testing if input material is not available  physical limits of the works including a description of the site boundaries and any connection points for services and access restrictions Preparing the Employer’s Requirements for a Construction Project PwC 246  a list of exclusions that have not been included in the D&B Contractor’s scope of work  interface obligations with existing plant and/or auxiliary works  interaction between the D&B Contractor and other Contractors  interface obligations with adjoining property Owners  plant or material to be supplied by the Employer  training the D&B Contractor must provide to Employer’s personnel  future Operator/Owner access requirements for maintenance and repairs  permits or approvals that the D&B Contractor is required obtain  an exclusive list of Employer’s responsibilities such as obtaining planning approvals and supplying facilities, equipment or materials  project-safety, quality and coordination policies, plans or procedures which the D&B Contractor is required to comply with or prepare  approved working hours and any requirements or restrictions as to working hours  defect rectification – Period and access requirements  Sub contractor and supplier warranties for specific works or materials or services for which the Employer wants a direct ongoing contractual relationship with the sub contractor, manufacturer or supplier in relation to performance and defect rectification. Stage 6 – Global review of the D&B contract documents Ideally, the Employer’s requirements and the general conditions should not be prepared in isolation. Unfortunately they often are, despite the significant costs to the Employer in procuring the commercial, technical and legal expertise required to perform this task. It is also not uncommon for the Employer’s requirements or documents prepared by the D&B Contractor (Contractor’s Proposal) to be simply attached to the general conditions and distributed as the tender documents without a thorough global review of all components of the D&B Contract. In practice the contract documentation, including the Employer’s requirements, will continue to evolve during the tender process and negotiations until the D&B Contract is executed. However, failing to undertake a review of the entire D&B Contract prior to going to tender increases the risk of ambiguity and uncertainty existing between the Employer’s requirements and the general conditions and various components of the Employer’s requirements. This will inevitably lead to a disputes and costly variations. The Employer cannot rely on inconsistencies or ambiguities being identified or raised by the D&B Contractor during the negotiation process. In fact, often Contractors will specifically look for ambiguity in contract documents during the tender process and internally identify ways to take advantage of any uncertainty during the performance of the works. For the same reason, the Employer should not include documents in the D&B Contract which have been prepared by the D&B Contractor, without a thorough review for consistency with the Employer’s requirements and general conditions. Another common cause of uncertainty is the use of unclear and inconsistent language in the Employer’s requirements. The drafting must definitively articulate the Employer’s requirements and the obligations of the parties. Using general motherhood statements or legalistic wording, rather than simple plain English drafting, will not only lead to uncertainty, costly disputes and/or variations, but also makes it more difficult and time consuming for the Employer’s project delivery team to determine what is to be constructed and to administer and enforce the D&B Contract. Preparing the Employer’s Requirements for a Construction Project PwC 247 The following paragraph, taken from an existing D&B Contract used on an actual project, provides an example of drafting that fails to definitively describe the required scope, standard or duration of the D&B Contractor’s design obligations in relation to designing temporary facilities and services: The Contractor shall provide good quality design services and the like for temporary facilities necessary which may be in use for a few years pending completion of final permanent building works or infrastructure/roads to the project and which will need to be compatible with the buildings in normal use for that time. The D&B Contractor’s obligations under the above paragraph are uncertain. An alternative drafting style that more definitively describes the D&B Contractor’s obligations might be: The Consultant must design all temporary facilities required at the site to ensure that all services to existing buildings are maintained for the duration of the project and for a period not less than 3 years after the completion of the project. The temporary facilities must be compatible and, fully interface with, all existing buildings at the site. While it is acknowledged that there are usually ambitious deadlines and budget restrictions imposed by Employers in relation to the contract procurement process, the global review, irrespective of the contract value, is critical. The review must combine input from the Employer’s project management team, technical consultants and legal advisors. It must also be centrally managed by personnel with the requisite skills set and combined expertise in contract procurement, contract administration, project delivery and legal drafting. PwC 248 Energy PwC 249 11 Construction, operation, regulatory and bankability issues for utility scale renewable energy projects Introduction Over the past 15 years, Australia’s renewable energy market has continued to attract massive interest from Developers, Contractors, manufacturers, governments and local and international investors. This reflects global energy trends driven by factors such as a push for diversification of energy sources and asset classes, government incentives for clean energy technology developments and, importantly, the decreasing cost of electricity from renewable energy sources. The renewable energy industry in Australia is well-established and mature for some technologies (eg wind, rooftop solar PV), developing in others (eg utility scale solar PV, solar thermal/CSP and hybrid solar) and at commercialisation stage in others (eg geothermal, wave). At this time of increasing market interest and development, it is relevant to consider key issues and market trends in the construction, operation and regulatory aspects of projects, and critical bankability considerations relating to each of these issues. While this paper focuses on issues that are of most interest to project Sponsors and Lenders, many of these considerations are equally relevant to Contractors. This paper considers these issues in the context of utility scale solar and wind projects in Australia. Overview of the current state of renewable energy in Australia Renewable energy sources (comprised of solar PV, solar thermal, wind, hydro, wave, tidal and geothermal) contributed around 13.5% of Australia’s electricity generation in the 2014 calendar year1 , down from 14.76% in 2013. This fall in generation was mainly attributed to lower rainfall in hydro catchment areas. Of this amount, the largest contributions were from hydro (45.9%), wind (30.9%) and solar (15.3%)2 . There was a significant scaling back in investment in 2014, with spending on large-scale renewables falling approximately 88% to $240.0 million in the calendar year3 . This was a consequence of significant uncertainty surrounding the proposed reduction of the Federal Government’s Renewable Energy Target and the potential abolition of the Clean Energy Finance Corporation and the Australian Renewable Energy Agency. Despite the recent reduction in overall spending there has been a continued increase in the level of energy generated from renewable sources; an overview of energy generation from renewable sources is provided below4 . 1 Clean Energy Council, Clean Energy Australia Report 2014, http://www.cleanenergycouncil.org.au/policy-advocacy/reports.html 2 Clean Energy Council, Clean Energy Australia Report 2014, http://www.cleanenergycouncil.org.au/policy-advocacy/reports.html 3 Time for Tony Abbott to join renewable energy’s flow’, Sydney Morning Herald, 22 January 2015, http://www.smh.com.au/comment/smh-editorial/timefor-tony-abbott-to-join-renewable-energys-flow-20150122-12qlrn.html 4 Australian energy statistics update 2015 http://www.industry.gov.au/Office-of-the-Chief-Economist/Publications/Pages/Australian-energy-statistics.aspx# Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 250 Australian energy generation from renewable sources Whilst investment in large scale renewable technology dropped by 88% in 2014, investment in household renewable energy dropped by only 20% in 2014. With the new change in leadership of the Coalition government, there are indications that Malcolm Turnbull’s approach to renewable energy will hopefully incentivise industry and households to invest in renewable technologies. Overview by technology Solar PV in Australia Despite having some of the highest average solar radiation per square metre of any continent in the world and with world-leading capabilities in solar PV research and technology development, to date Australia has lagged in the development of utility scale solar PV facilities. Currently, the four main operating utility scale PV facilities are the:  20 MW Royalla solar farm developed by FRV in the ACT, which began generation in September 2014  10 MW solar PV plant developed in 2012 at Greenough River in WA by Verve Energy, GE Energy Financial Services and First Solar  102 MW Nyngyn Solar Plant in western NSW developed by AGL and First Solar in 2015  53 MW solar PV facility at Broken Hill developed by AGL and First Solar in 2015. Solar Choice is expected to commence construction on Australia’s biggest solar farm early this year. The solar plant, which is located west of Toowoomba in Queensland, is expected to generate up to two gigawatts (2,000MW) once completed5 . In contrast, the small-scale rooftop solar PV sector has undergone rapid development. In the year to the end of 2014, a total of 4,040.65 MW of solar PV was installed across Australia. A total of 1.42 million small-scale solar systems were installed by the end of 20146 . 5 Solar Choice, Solar Choice’s 2GW Bulli Creek Solar Farm: The lay of the land, 17 June 2015, http://www.solarchoice.net.au/blog/solar-choice-bulli-creeksolar-farm-lay-of-the-land and RPS, Bulli Creek Solar Farm, Darling Downs, QLD http://www.rpsgroup.com/Australia-Asia-Pacific/Projects/Bulli-CreekSolar-Farm,-Darling-Downs,-QLD.aspx 6 Clean Energy Council, Clean Energy Australia Report 2014, http://www.cleanenergycouncil.org.au/policy-advocacy/reports.html 0 5000 10000 15000 20000 25000 30000 35000 40000 1992–93 1996–97 2000–01 2004–05 2008–09 2012–13 G w h Geothermal Solar PV Biogas Biomass Wind Hydro Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 251 The rapid increase since 2008 has been primarily led by dramatic reductions in the relative cost of small-scale solar PV. This has been driven by a combination of supportive government policy environment and incentives, technological maturation, economies of scale (with rapid expansion in the global production of PV modules) and changes to the price of input costs, in particular, substantial decreases in the price of polysilicons7 . However, the domestic solar market experienced a significant contraction in 2014. Approximately 187,000 solar power systems were installed nationwide in 2014, down from 213,000 in 2013. This primarily reflects the impact of the roll back of state-based solar incentive schemes. However, the continuing downward trend in system costs is expected to provide a sustainable future for the industry, albeit after a period of consolidation. The scale of household solar PV is understood to be playing an increasing role in relieving pressure on the networks, particularly in reducing peak energy demand. This was illustrated during the January 2014 heatwave across the southern states of Australia, where commentators estimate that rooftop solar PV contributed between 2.5-2.8% towards meeting peak demand, and caused the demand peak to be lower and later in the day than would otherwise have occurred8. Solar thermal While still in its infancy in Australia, a small number of solar thermal (also known as “concentrating solar power” or CSP) facilities have been, or are being, developed. In most cases, these are conversions of, or additions to, existing coal-fired power stations rather than stand-alone facilities. For example, a 9.3MW concentrated solar thermal station was added to the existing Liddell coal-fired power station in NSW, and in Queensland a 44MW plant is under construction to feed steam to an existing coal-fired facility at Kogan Creek power station. There are also a number of feasibility studies being conducted into the use of solar thermal in remote and off-grid areas. It is expected that solar thermal technologies will be used in the ACT government’s 2015 Next Generation Solar process. Wind Wind currently remains the lowest cost form of renewable energy that can be rolled out on a large scale and, as such, continues to dominate the renewable energy marketplace. The amount of wind power generated in Australia has doubled over the past 5 years. The Macarthur Wind Farm (developed by AGL and Meridian Energy with a current 50/50 ownership by Morrison & Co and Malakoff as a result of a sale by AGL in September 2015) came online in April 2013 and, at 420 MW, is now the largest wind farm in Australia. At the end of 2014 there were 1,866 wind turbines spread across 71 operating wind farms, supplying more than 4.0% of Australia’s overall electricity consumption9 . In July 2015, the Bald Hills wind farm in Victoria commenced operation, with 106 MW of capacity. A significant number of other wind farms have been approved but are not yet operational. Like solar, the large number of wind projects in development reflects factors such as the quality of wind resources in Australia, particularly along the southern coasts which are regarded as among the best in the world. The cost of wind generation technology has significantly reduced over recent years10. 7 Australian Bureau of Resource and Energy Economics, Energy in Australia, 2013, http://www.bree.gov.au/documents/publications/energy-in-aust/breeenergyinaustralia-2013.pdf 8 Giles Parkinson, ‘Solar puts heat on big generators as demand peaks subside’ RenewEconomy, 17 January 2014, http://reneweconomy.com.au/2014/solar- 23763 9 Clean Energy Council, Clean Energy Australia Report 2014, http://www.cleanenergycouncil.org.au/policy-advocacy/reports.html 10 Australian Bureau of Resource and Energy Economics, Energy in Australia, 2013, http://www.bree.gov.au/documents/publications/energy-in-aust/breeenergyinaustralia-2013.pdf Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 252 Renewable energy policy and legislative framework – Federal The key policy mechanism driving renewable energy investment in Australia is the Renewable Energy Target (RET). The regulatory framework that establishes the RET is set out in the Renewable Energy (Electricity) Act 2000 (Cth) (Act). When passed as legislation, the Act set a target for renewable energy generation from eligible renewable energy power stations in Australia of 41,000GWh by 2020. This represented a target of 20% of Australia’s electricity being supplied by renewable sources by 2020 and maintained at this level until 2030. In June 2015, however, the Coalition Government passed legislation to cut this target to 33,000GWh. This figure reflects the recommendation in the Warburton Review of the RET, discussed below. The rationale, in part, for this change was to reflect overall lower energy demand and represent a ‘real 20%’ figure. At the end of 2013, the generating capacity of large-scale renewable power stations was approximately 13,100GWh of eligible renewable energy (as defined under the Act) per year, with an additional 6,400GWh contributed by small-scale systems. A study by consultancy firm SKM MMA11 found that the RET had delivered $18.5 billion of investment in renewable energy since 2001, and forecast that the RET would drive a further $18.7 billion of investment between 2012 and 2020. The revised RET is still expected to unlock significant investment, of approximately $10 billion12 . The RET drives investment by creating a guaranteed market for additional renewable energy deployment using a mechanism of tradable Renewable Energy Certificates (RECs). RECs are market-based instruments generated by accredited renewable energy power stations and that can be traded and sold. Demand for RECs is created by a legal obligation that the Act places on parties who buy wholesale electricity (retailers and large users of electricity known as ‘liable entities’) to purchase and surrender a certain amount of RECs each year. During 2009 and 2010, strong demand for small-scale renewable technologies, including solar hot water and residential solar PV, meant that an increasingly large number of RECs were entering the market from smallscale technologies. This led to market volatility and depressing of REC prices, which caused investment uncertainties and delays for large-scale renewable energy projects. In June 2010, Federal Parliament passed legislation to split the RET into the Large-Scale Renewable Energy Target (LRET) with Large-Scale Generation Certificates (LGCs) and the Small-Scale Renewable Energy Scheme (SRES) with Small-Scale Technology Certificates (STCs). The LRET covers large scale renewable energy projects including wind farms, utility scale solar PV and solar thermal, hydro and geothermal, whereas the SRES covers small-scale technologies such as residential rooftop solar PV and solar hot water systems. The reforms are aimed to allow the market to set a LRET price to provide incentives for large-scale renewables. As the increasing obligation of liable entities to purchase LRECs to 2020 increases demand, LREC prices are expected to increase, supporting the investment and expansion of large-scale renewable energy generation. The RET scheme has been designed such that the majority of the RET will be delivered by large-scale renewable energy projects. The LRET includes legislative annual targets, starting at 10,000GWh in 2011 and increasing to 33,000GWh in 2020 and remaining at that level until 2030. Under the LRET, accredited renewable energy power stations are entitled to create one LGC for each MWh of electricity generated which can then be sold and transferred to liable entities using the REC Registry. Power stations using at least one of the more than 15 types of “eligible renewable energy sources” can become accredited. Under the SRES, Owners of small-scale technology will receive one STC for each MWh generated by the smallscale system or displaced by the installation of a solar hot water heater or heat pump. In contrast to LGCs, STCs are available upfront on the installation of the system rather on an ‘as generated’ basis. The SRES is an uncapped scheme in that its annual targets are set based on the number of SRECs expected to be created in that year. Liable entities are required to purchase an amount of both LGCs and STCs and surrender them on an annual basis (for LGCs) and a quarterly basis (for STCs). Liable entitles may purchase LGCs directly from renewable energy power stations or from agents dealing in LGCs. The market price of LGCs is dependent on supply and 11 SKM MMA, Benefits of the Renewable Energy Target to Australia’s Energy Markets and Economy, 2012 12 ‘New renewable energy target to unlock $10b worth of deals, GE says’, The Age, 24 June 2015, http://www.theage.com.au/business/energy/australiasrenewable-energy-target-to-unlock-10b-worth-of-deals-ge-says-20150624-ghwanx.html Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 253 demand and has varied between $10 and $6013. Liable entities may purchase STCs through an agent who deals with STCs or through the STC clearing house. There is a government-guaranteed price of $40 for all STCs sold through the clearing house, but no price is set for STCs sold in the market. If a liable entity does not meet its obligations under the Act, it must pay a “shortfall charge”, currently set at $65 per LGC or STC not surrendered. The Act requires a review of the RET to be conducted every two years by the Climate Change Authority. The most recent review was conducted in 2012 and the key recommendation was that the RET should be left largely untouched to preserve investor confidence. For the 2014 RET review, the Coalition Government appointed, in place of the Climate Change Authority, a panel of experts headed by Mr Dick Warburton to conduct the review with the support and involvement of the Departments of Prime Minister and Cabinet, Industry and Environment (the Warburton Review). The review is required to report to Government by mid-2014. The terms of reference for the review were released in February 201414 and include:  whether the objective of the RET scheme, to deliver 41,000 gigawatt hours (GWh) and small scale solar generation by 2020, is still appropriate  the extent of the RET's impact on electricity prices, and the range of options available to reduce any impact while managing sovereign risk  implications of projected electricity demand for the 41,000 (GWh) target. The Warburton Review handed down its final report in August 2014, finding that the RET had broadly met its objectives of increasing large-scale and small-scale generation and reducing carbon emissions. However, the report stated that the additional $22.0 billion NPV in cross-subsidy to the renewables sector expected over the remainder of the scheme, and the additional $15.0 billion in renewable investment that this would encourage, was not necessary to meet likely growth in electricity demand, which could be met from existing generation capacity. Consequently, on the basis that the scheme “[diverts] resources from more productive uses elsewhere in the economy”15 , the Warburton Review recommended:  that the LRET should be amended in one of two ways: – by closing the scheme to new entrants (excepting power stations already under construction) – by implementing a "real 20.0%" target, setting future annual targets through to 2020 on the basis of a 50.0% share of growth in electricity demand.  that the SRES should be abolished, or its last year of operation brought forward from 2030 to 2020 and the number of certificates created under it reduced. The findings of the report were endorsed by the Coalition Government, and were the platform for its policy to reduce the RET. In October, the Government publicly stated that its position on renewable policy was that the RET should pursue a “real 20.0%” target, and that pressure on energy intensive trade exposed sectors should be reduced16. The figure initially suggested was 27,000GWh. Strong opposition from Labor, the Greens and some independents in the Senate led to a compromise of a reduction in the RET to 33,000GWh. It is hoped that settling the new RET will remove uncertainty in the renewable energy market, which had contributed to spending on large-scale renewables falling approximately 88.0% to $240.0 million in the calendar year17 . 13 Clean Energy Regulator, Increasing Australia’s renewable electricity generation, http://ret.cleanenergyregulator.gov.au/ 14 Environment Minister Greg Hunt, Media Release – Review of the Renewable Energy Target, 17 February 2014, http://www.environment.gov.au/minister/hunt/2014/pubs/mr20140217.pdf 15 RET Review Panel, Renewable Energy Target Review – Report, https://retreview.dpmc.gov.au/ret-review-report-0 16 The Hon Ian Macfarlane MP, ‘Renewable Energy Target’ (Press Release, 22 October 2014) http://www.minister.industry.gov.au/ministers/macfarlane/media-releases/renewable-energy-target 17 ‘Time for Tony Abbott to join renewable energy’s flow’, Sydney Morning Herald, 22 January 2015, http://www.smh.com.au/comment/smh-editorial/timefor-tony-abbott-to-join-renewable-energys-flow-20150122-12qlrn.html Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 254 Australia fell from 11th largest investor in large-scale renewable energy projects in 2013 to 39th in 201418. The new legislation also allays an fears of political and sovereign risk, which could have caused major bankability impacts of current and future renewable energy projects. Renewable energy policy and legislative framework – Commonwealth Carbon Pricing Mechanism and the Clean Energy Plan In July 2014, Parliament passed the Clean Energy Legislation (Carbon Tax Repeal) Act 2014 (Cth), which repealed the Carbon Pricing Mechanism (CPM) that had been in place since July 2012. The CPM was originally introduced by the Clean Energy Act 2011 (Cth) and the associated package of legislation comprising the former Labor Government’s Clean Energy Plan. Under the CPM, liable entities were required to purchase and surrender to the Federal Government a permit for every tonne of greenhouse gas emissions that it emits that is covered by the CPM. The price of permits was to be fixed for the first three years of the CPM. It was intended that, from 1 July 2015, the price of permits would be set by the market and the number of permits issued by the Federal Government will be capped based on emissions data. It was proposed for the CPM to link with the EU emissions trading scheme from 2015. Although the CPM did not directly incentivise renewable energy development, putting a price on carbon was intended to provide an economic driver to incentivise investment in renewable energy in preference to emissions- intensive fossil fuel derived energy. Other measures implemented by the previous federal government included the creation of the Clean Energy Finance Corporation (CEFC) and the Australian Renewable Energy Agency (ARENA). The CEFC was created to facilitate and coordinate up to $10 billion of investment in renewable energy, enabling technologies, energy efficiency and low-emissions technologies. The aim of the CEFC is to unlock significant new private sector investment by providing equity investments, commercial loans and loan guarantees, with equity to be reinvested in the CEFC. ARENA is an independent statutory body established with the aim of making renewable energy solutions more affordable and to increase the amount of renewable energy used in Australia. It was announced with an initial budget of $3.2 billion (later revised to $2.5 billion) in government funding to manage until the year 2022 to support a range of projects and technologies, with a particular focus on emerging and newly developed technologies and improvements, renewable energy in regional areas and knowledge sharing. Following the 2013 Federal Government elections, the new Coalition Government introduced a package of 11 pieces of legislation into Federal Parliament that propose to abolish the CPM, the CEFC and the Climate Change Authority and to make further changes to a range of other measures associated with the previous Labor Government’s clean energy plan. Whilst the CPM was repealed in July 2014 the majority of the Government’s other measures were repeatedly blocked by the Senate. Most recently, AGL announced that it will set up a new investment fund which it believes will generate up to $2- 3 billion worth of investment in renewable energy projects. The Powering Australian Renewables Fund is expected to deliver about 1000 megawatts of new renewables which represents about 20% of the total generation required to meet the current 2020 RET target. AGL will contribute $200 million in equity and will seek investment partners for the new fund (such as super funds and banks).19 This fund is expected to incentivise companies to participate in renewable energy projects by sharing the funding risk across a portfolio of projects, rather than a single project. 18 ‘Clean energy sector ‘uninvestable’ due to renewable energy target uncertainty, analyst says’, Australian Broadcasting Corporation, 12 January 2014, http://www.abc.net.au/news/2015-01-12/ret-clean-energy-sector-uninvestable-analyst-says/6013090 19 Clean Energy Council, AGL tests the wind with new renewable energy fund, 10 February 2016 https://www.cleanenergycouncil.org.au/news/2016/February/agl-new-powering-australian-renewable-energy-fund-windsolar.html#sthash.IXeUdWTZ.dpuf Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 255 Direct action plan The Federal Coalition Government’s policy framework for clean energy and carbon reduction measures consists of a range of measures comprising the Direct Action Plan. The centrepiece of the Direct Action Plan is the Emissions Reduction Fund (ERF), which has the stated aim of providing incentives for abatement activities across the Australian economy. At present, the ERF has been capped at $2.55 billion over 4 years. There are three components to the ERF:  Crediting emission reductions – Participants are to be issued with one Australian Carbon Credit Unit (ACCU) for each tonne of carbon dioxide equivalent stored or avoided through registered projects. The ACCUs can be traded and sold. Eligible activities include (but are not limited to) landfill gas capture, energy efficiency and land sector projects.  Purchasing emissions reductions – Participants with registered projects can: – apply to enter into a contract with the Clean Energy Regulator to sell ACCUs to the Clean Energy Regulator through an auction process – sell their ACCUs in the secondary market – hold their ACCUs to offset emissions.  Safeguarding emissions reductions – This component will be introduced on 1 July 2016 through a mechanism which aims to safeguard against the volume of emissions reductions being outweighed by significant emissions increases above business as usual levels. In October 2014, the Parliament passed the Carbon Farming Initiative Amendments Act 2014, which amends the Carbon Credits (Carbon Farming Initiative) Act 2011 to give effect to the ERF. Existing Carbon Farming Initiative Projects have been transitioned to the ERF. To date, there have been 2 auctions of Australian Carbon Credits under the scheme. The 2015 Energy White Paper provides very little guidance on how the Coalition will achieve its RET. Renewable energy policy and legislative framework – State Planning and environmental approvals State-based planning systems and associated guidelines will also impact upon aspects of renewable energy development such as the siting and design of wind farms and solar PV farms. For example, in Victoria, the Policy and Planning Guidelines for Development of Wind Energy Facilities in Victoria (January 2016)20 (guidelines) provide guidance about suitable locations for wind energy facilities, a framework to ensure the thorough assessment of proposals for wind energy facilities and inform planning decisions in relation to a wind energy facility, including in relation to compliance with the Victorian Planning Provisions and the State Planning Policy Framework. Under the guidelines, wind turbines are excluded from (among other places) listed geographical areas (including the Yarra Valley, Dandenong Ranges, Bellarine and Mornington Peninsulas) and will not be permitted to be built within one kilometre of an existing dwelling without the written consent of the Owner of the dwelling. Similar legislation has been enacted in other jurisdictions including NSW. 20 Department of Environment, Land, Water and Planning, Policy and planning guidelines for development of wind energy facilities in Victoria http://www.dtpli.vic.gov.au/__data/assets/pdf_file/0011/231779/Policy-and-Planning-Guidelines-for-Development-of-Wind-Energy-Facilities-inVictoria_January-2016.pdf Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 256 All types of renewable energy, and wind energy in particular, have been the subject of debate generated by a small number of extremely vocal community groups. Recently, the Victorian Civil and Administrative Tribunal21 directed the Mitchell Shire Council’s decision to be set aside and a planning permit be granted to develop the Cherry Tree Wind Farm Pty Ltd near Seymour in Victoria, subject to the conditions set out in the decision. At paragraph 47 of its reasons, the Tribunal noted “[T]here is not sufficient evidence to establish that the proportion of the population residing in proximity to a wind farm which experiences adverse health effects is large enough to warrant refusal of a land use that is positively encouraged by planning policy.” The Tribunal in that case referred to a number of studies, including publications from the Victorian Department of Health and others that expressly state that there is no scientific evidence to link wind turbines with adverse health effects. In February 2015, the National Health and Medical Research Council (NHMRC)22 , Australia’s peak medical and scientific research body, released an information paper finding that no reliable evidence exists that wind farms directly cause health issues. The paper considered nearly 2000 published references and around 249 public submissions addressing noise, shadow flicker and electromagnetic radiation produced by wind farms. Further discussion regarding the environmental impacts of the development of renewable energy projects is set out below. State government policies to facilitate renewable energy investment A large number of policies to facilitate the development of and investment in renewable energy, particularly for small-scale solar PV, have been implemented by various state governments across Australia. The ACT Government has recently been among the most active of the State and Territory Governments in terms of driving investment in medium and large scale wind and solar PV projects. These policies are driven by the ACT’s targets of 90% of energy from renewable sources by 2020, 40% reduction in greenhouse gases by 2020 and carbon neutrality by 2060. During 2012, the ACT Government issued an RFP for a ‘reverse auction’ under which bids were submitted to enter into a 20 year feed-in tariff for up to 40 MW of large-scale solar PV projects. The scheme was heavily oversubscribed. The 20 MW Royalla Solar Farm developed by FRV was awarded the fast track stream in September 2012 and reached financial close in August 2013. In August 2013, two further projects – Zhenfa’s 13 MW Mugga Lane Solar Farm and the 7 MW OneSun Capital Solar Farm – were also awarded feed-in tariffs. An independent review tabled by the ACT Environment Minister found that the reverse solar auction process was effective, generated strong competition, resulted in positive industry feedback and provided value for money for consumers. 23 In March 2014, the ACT Government enacted legislation to expand the scope of the large-scale renewables feedin tariff scheme to lift the current 210MW cap to 550MW and to expand its application to projects in the Australian Capital Region and beyond in certain circumstances. The ACT Government also announced that it would expand the scope of the large-scale feed-in tariff scheme to incorporate auctions for wind and waste-toenergy projects, as well as further solar PV projects. The ACT Government also has a medium-scale renewable energy feed-in tariff in place. The large-scale feed-in tariff scheme incorporated an auction process for 200 MW of wind powered generation facilities, which was closed in September 2014. The ACT Government received 18 submissions, with a combined generation capacity of more than 1,000 MW24. The winning bidders are expected to provide 24.0% of the ACT’s electricity consumption. The three successful projects were:  Coonooer Bridge Wind Farm, developed by Windlab  Hornsdale Wind Farm, developed by Neoen and Megawatt Capital 21 Cherry Tree Wind Farm Pty Ltd v Mitchell Shire Council P2910/2012, 26 November 2013, http://www.vcat.vic.gov.au/sites/default/files/cherry_tree_wind_farm_pty_ltd_v_mitchell_shire_council_decision.pdf 22 National Health and Medical Research Council, Information Paper – Evidence on Wind Farms and Human Health, February 2015 https://www.nhmrc.gov.au/_files_nhmrc/publications/attachments/eh57a_information_paper.pdf 23 ACT Government, Environment and Sustainable Development Directorate, ACT Solar Auction Review, October 2013 http://www.environment.act.gov.au/__data/assets/pdf_file/0004/581602/ACT_Solar_Auction_Review_-_Summary_Report.pdf 24 Environment and Planning Directorate, ‘Strong bidding in wind auction good news for Canberra’, 8 September 2014, http://www.cmd.act.gov.au/open_government/inform/act_government_media_releases/corbell/2014/strong-bidding-in-wind-auction-is-good-news-forcanberra Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 257  the Ararat Wind Farm, developed by RES. In August 2015, the ACT Government invited interested parties to participate in its Second Wind Auction. One of the successful projects is for a 100MW wind farm proposed by Hornsdale Wind Farm (Stage 2). The wind farm is to be developed by Neoen in partnership with Megawatt Capital and will be located south-east of Port Augusta, South Australia. South Australia has a renewable energy target of 50% by 2025, whilst Queensland aims to achieve the same target by 2030. It is expected that Queensland will undertake a 40MW renewables reverse auction in the short term. Certain local governments in NSW and Victoria are promoting Environmental Upgrade Funding, a method of financing that provides funding from $250,000 to $10 million plus for the retrofitting of commercial buildings with ‘sustainable’ features such as energy efficiency lighting and heating/cooling, in addition to small solar PV installations. A number of Lenders are offering special products for Environmental Upgrade Agreements in tandem with local governments with competitive interest rates compared with traditional lending. Features of wind and solar facilities Wind facilities A wind farm typically comprises a series of wind turbines, a substation, cabling (to connect the wind turbines and substation to the electricity grid), wind monitoring equipment and temporary and permanent access tracks. The wind turbines used in commercial wind farms are large rotating, three bladed machines that typically produce between 1MW and 3MW of output. Each wind turbine is comprised of a rotor, nacelle, tower and footings. The height of a tower varies with the size of the generator but can be as high as 100m. The number of turbines depends on the location and capacity of turbines. The amount of power a wind generator can produce is dependent on the availability and the speed of the wind. The term “capacity factor” is used to describe the actual output of a wind energy facility as the percentage of time it would be operating at maximum power output. Wind farms need to be located on sites that have strong, steady winds throughout the year, good road access and proximity to the electricity grid. Australia has one of the world’s best wind resources, especially along the southeast coast of the continent and in Tasmania. Solar PV facilities Solar PV facilities utilise PV cells which are assembled to form PV panels or modules that are then lined up into solar arrays, PV cells convert sunlight into electric current using the photoelectric effect. Most solar arrays use an inverter to convert the DC power produced by the PV panels into AC power. Solar PV plants can use either fixed-mount solar arrays or automated tracking systems that allow the solar arrays to follow the sun’s daily path across the sky and optimise electricity production. A solar PV facility typically comprises a series of PV panel arrays and inverters, mounts, trackers (if used), cabling, monitoring equipment, substation and access tracks. The amount of electricity generated by a PV facility will be dependent on a number of factors including the type and positioning of the panels and whether trackers are used. Solar thermal facilities There are four primary technologies used in solar thermal facilities – Parabolic trough, solar tower, fresnel refractors and solar dish. Of these, the technology used in parabolic trough facilities is currently the most commercially mature, being used in 94% of solar thermal projects worldwide, followed by that used in solar tower facilities. The basic features of a solar thermal facility vary by technology but are essentially comprised of an array of mirrors used to concentrate sunlight and produce heat and steam to generate electricity using the conventional thermodynamic cycle. In parabolic trough projects, for example, curved mirrors concentrate the sun’s rays on a focal line and synthetic oil, steam or molten salt is used to transfer the solar heat to a steam generator. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 258 One of the main features driving the commercialisation of solar thermal technology is the ability to incorporate storage systems using synthetic oil or molten salt. Some solar thermal facilities with molten salt storage have storage capacities of 6-15 hours, which increase the capacity factors of the plants significantly. Contractual structure The diagram below illustrates the basic contractual structure of a typical project financed renewable energy project. The detailed contractual structure will vary from project to project. For example, in some wind and hydro projects, the scope of work generally performed under an EPC Contract is split into a Turbine Supply Contract and a Balance of Plant (BOP) Contract, with the performance guarantees during the operating phase of the facility dealt with in a warranty operating and maintenance contract (WOM). However, for the purpose of this paper we have examined a project with the basic structure illustrated above. As can be seen from the diagram, the Project Company25 will usually enter into following agreements comprising the project documents:  Construction contract – Governs various elements of the construction of the facility including the supply and assembly of equipment (such as turbines or PV panels) and construction of the balance of the plant comprising civil and electrical works. As outlined above, there are a range of contracting methods that may be used, from an EPC Contract (under which a Contractor is obliged to deliver a complete facility to a Developer who need only ‘turn a key’ to start operating the facility) to a split contracting structure (with the supply, design and construction of the facility all performed by separate parties, with or without a project manager). The choice of contracting approach will depend on a number of factors including the time available, Lender requirements, identity of the Contractor(s) and whether the Contractor is willing to ‘wrap’ or guarantee the performance of the components of the facility (eg panels, turbines). The major advantage of the EPC Contract over the other possible approaches is that it provides for a single point of responsibility. This is discussed in more detail below. In our experience most utility scale renewable energy projects use EPC Contracts. 25 Given this paper focuses on project financed infrastructure projects we refer to the Employer as the Project Company. Whilst project companies are usually limited liability companies incorporated in the same jurisdiction as the project is being developed in the actual structure of the Project Company will vary from project to project and jurisdiction to jurisdiction Lenders EPC Contractor O&M Contractor Network Distributor Sponsors Offtaker Project Company Engineer, Procure and Construct (EPC) Contract Operation and Maintenance (O&M) Contract Connection Agreement Power Purchase Agreement (PPA)/ Offtake Agreement Equity Support Agreement Financing and Security Agreements Tripartite Agreements Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 259 Interestingly, on large project financed projects the Contractor is increasingly becoming one of the Sponsors, (ie an equity participant in the Project Company). Contractors will ordinarily sell down their interest after financial close because, generally speaking, Contractors will not wish to tie up their capital in operating projects. In addition, once construction is complete the rationale for having the Contractor included in the Ownership consortium no longer exists. Similarly, once construction is complete a project will normally be reviewed as lower risk than a project in construction and therefore, all other things being equal, the Contractor should achieve a good return on its investment when selling down  Operation and maintenance contracts – Are generally comprised of a long-term operating and maintenance contract (O&M contract) with an Operator, though the term will vary from project to project depending on factors such as the location, technology and PPA available. The Operator may be a Sponsor, particularly if one of the Sponsors is an independent power producer or utility company whose main business is operating wind or solar facilities. In some financing structures the Lenders will require the Project Company itself to operate the facility. In those circumstances the O&M contract will be replaced with a WOM contract with the manufacturer and supplier of the major equipment supplied, for example, in the case of a wind farm, the wind turbine generators.  PPA or offtake agreement – Under which the Project Company will sell the electricity produced by the facility to a purchaser or ‘offtaker.’ In traditional project financed power projects there will be a power purchase agreement (PPA) between the Project Company and an offtaker such as an electricity retailer, large electricity consumer or government, under which the retailer or government undertakes to pay for a set amount of electricity for a specified amount of time, regardless of whether it actually takes that amount of electricity (referred to as a “take or pay” obligation). In turn, the Project Company will undertake to produce a minimum quantity of electricity. Sometimes a tolling agreement is used instead of a PPA, under which the power purchaser directs how the plant is to be operated and dispatched. Merchant power projects without a PPA in place do not have the same certainty of cash flow as they would if there was a PPA, and are generally considered higher risk than non-merchant projects. This risk can be mitigated by entering into synthetic PPAs or hedge agreements to provide some certainty of revenue. These agreements are financial hedges as opposed to physical sales contracts. These are discussed in further detail below.  Connection agreement – For connection of the facility’s generation equipment into the relevant grid or electricity distribution or transmission network between the Project Company and the Owner of the network (a transmission company, distribution company, electricity utility or small grid Owner/Operator). The connection agreement will broadly cover the construction and installation of connection facilities and the terms and conditions under which electricity generated by the facility will be exported into the grid. A connection agreement will not be required where the facility is not connected to the grid, such as in the case of a ‘captive’ facility with a single offtaker.  Concession agreement – In traditional power projects, a concession or project agreement is entered into between the Project Company and a government entity granting the Project Company a concession to build and operate the facility for a fixed period of time (usually between 15 and 25 years), after which it was handed back to the government. However, following the deregulation of electricity industries in many countries, merchant or independent power producer renewable energy projects are becoming increasingly prevalent. Merchant power projects do not normally require a concession agreement to be entered into – The Project Company will instead be required to obtain the necessary regulatory consents to construct and operate the project. The nature and extent of these approvals will vary from place to place, but will generally include planning, environmental and building approvals and approvals and licences to sell electricity into the market.  Financing and security agreements – With the Lenders to finance the development of the project. It is critical that the above-listed suite of documents that govern the development, construction and longterm operation of a renewable energy facility are, where practical, tailored so as to be consistent and aligned from a risk allocation perspective with the requirements of the other project documents. Further, it is vital to properly manage the interfaces between the various types of agreements. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 260 Bankability A bankable contract is a contract with a risk allocation between the Contractor and the Project Company that satisfies the Lenders. Lenders focus on the ability (or more particularly the lack thereof) of the Contractor to claim additional costs and/or extensions of time as well as the security provided by the Contractor for its performance. The less comfortable the Lenders are with these provisions, the greater amount of equity support the Sponsors will have to provide. In addition, Lenders will have to be satisfied as to the technical risk of the technology proposed and other project-specific features. Obviously price is also a consideration, but that is usually considered separately to the bankability of the contract because the contract price (or more accurately the capital cost of the facility) goes more directly to the bankability of the project as a whole. Before examining the requirements for bankability, it is worth briefly considering the appropriate financing structures and lending institutions. The most common form of financing for infrastructure projects is project financing. Project financing is a generic term that refers to financing secured only by the assets of the project itself. Therefore, the revenue generated by the project must be sufficient to support the financing. Project financing is also often referred to as either “non-recourse” financing or “limited recourse” financing. The terms “non-recourse” and “limited recourse” are often used interchangeably, however they mean different things. “Non-recourse” means there is no recourse to the project Sponsors at all and “limited recourse” means, as the name suggests, there is limited recourse to the Sponsors. The recourse is limited both in terms of when it can occur and how much the Sponsors are forced to contribute. In practice, true non- recourse financing is rare. In most projects the Sponsors will be obliged to contribute additional equity in certain defined situations. Traditionally project financing was provided by commercial Lenders. However, as projects became more complex and financial markets more sophisticated, project finance also developed. The size of the debt required to develop a complex project means that in many cases the debt will be syndicated across multiple commercial Lenders. Additional mezzanine and other subordinated forms of debt may also be used. Whilst commercial Lenders still provide finance, governments now also provide financing either through export credit agencies26 or trans or multinational organisations like the World Bank, the Asian Development Bank and European Bank for Reconstruction and Development. Sponsors are also using more sophisticated products like credit wrapped bonds, securitisation of future cash flows and political risk insurance to provide a portion of the necessary finance. For example, in 2013 a ZAR 1,000,000,000 (approximately than AU$100 million) solar financing bond was issued by an affiliate of Soitec Solar to finance the construction of a 44 MW utility-scale concentrator photovoltaic (CPV) solar power plant in Touwsrivier, South Africa27 . In assessing bankability, Lenders will look at a range of factors and assess a contract as a whole. Therefore, in isolation it is difficult to state whether one approach is or is not bankable. Generally speaking the Lenders will require the following elements to be included for a contract to be considered to be ‘bankable’:  A fixed completion date  A fixed completion price  No or limited technology risk  Output guarantees  Liquidated damages for both delay and performance  Security from the Contractor and/or its parent 26 Export credit agencies are bodies that provide finance on the condition that the funds are used to purchase equipment manufactured in the country of the export credit agency 27 http://www.soitec.com/en/investors/financial-press-releases/soitec-completes-zar-1-000-000-000-inaugural-solar-financing-bond-transaction-in-southafrica-1275/ Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 261  Large caps on liability (ideally, there would be no caps on liability, however, given the nature of EPC Contracting and the risks to the Contractors involved there are almost always caps on liability)  Restrictions on the ability of the Contractor to claim extensions of time and additional costs. An EPC Contract delivers all of the requirements listed above in one integrated package. This is one of the major reasons why they are the predominant form of construction contract used on large-scale project financed infrastructure projects. Lenders have become comfortable with the interface risk arising in a split EPC structure and will focus on the remedies for underperformance in the WOM. Sponsor support In certain cases, it may be necessary to provide Sponsor support to strengthen the capacity of the Project Company to satisfy its obligations to the banks and to have a “bankable” project. Forms of Sponsor support may include equity subscription agreements (base and standby equity), completion guarantees of whole or part of the debt until the project commences commercial operation, bank guarantees to support the completion guarantee and cost overrun guarantees/facility. Completion guarantees, for example, ensure that the Lenders will be paid back a set amount if the facility does not reach completion or the repayment of scheduled debt service, of Principal plus interest, if completion is delayed. Other forms of support may be incorporated where the Sponsor is a party to a key project contract (such as a construction contract, O&M agreement or offtake agreement) by requiring the Sponsor to provide additional guarantee letters of credit or corporate support to underpin the project. Merchant PPA As noted above, to ensure certainty of revenue project Sponsors will generally prefer to enter into a long-term PPA in respect of the energy produced by a renewable energy facility. Where this is not available or not available on terms satisfactory to the Sponsors, the Sponsors will be required to enter into merchant arrangements and sell directly into the electricity spot market. For a fully merchant project (FMP), versus a fully or partly contracted project, from the Sponsor perspective the expected IRR will obviously need to increase to account for the significantly increased risk in returns the project will experiencing due to exposure to spot prices. Some FMPs may seek to implement an electricity hedge programme to reduce pricing risk in an otherwise merchant transaction. Beyond the amount of generation hedged and beyond the term of the implemented hedge, spot market pricing risk will remain. If the project and the Lenders required these hedges, their renewal on expiry (ie rolling hedges) would most likely need to be documented to involve the Lenders, or otherwise meet pre-agreed minimum criteria. Any Lender requirement for long term foundation hedges will come down to being able to model an acceptable return for the Sponsor and Lenders. Lenders will also look to the credibility and financial strength of any offtake swap providers. In some cases, the Lenders’ own internal energy trading desk may be involved, provided there is a certain level of certainty regarding expected generation from the facility. It can generally be anticipated that both the gearing and ratios for a FMP will be higher than for projects with full or partial PPAs in place. Gearing could be expected to be around 45-50% for an FMP, as opposed to 60-75% for a project which had hedged/set prices for whatever it was able to generate. Our understanding is that the gearing for a recent Australian merchant wind project was 50%, but since then merchant prices have declined along with price forecasts, which could push gearing even lower. From a Lenders’ perspective, with a long term PPA in place with known price for an accepted generation profile contracted, Debt Service Cover Ratios could be expected to be around 1.40x. If the price for the entire generation profile is not known however, given the spot price risk a DSCR of around 2.0x may be required (on a conservative forward price assumption). The higher DSCR is required on the basis that it is anticipated that far greater revenue will need to be achieved for the scheduled debt service costs. We understand that some Lenders are contemplating the possibility of using a blended DSCR in modelling the bankability of renewable energy projects. For example, if 30% of anticipated generation is the subject of a hedge, that portion of the project may have a DSCR of 1.4x. The remainder of anticipated generation (including Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 262 the tail end of the contracted portion, which a financier would assume reverts to spot price risk) would need to achieve a higher DSCR, say around 2.0x. Basic features of an EPC Contract The key clauses in any construction contract are those that impact on time, cost and quality. The same is true of EPC Contracts. However, EPC Contracts tend to deal with issues with greater sophistication than other types of construction contracts. This is because, as mentioned above, an EPC Contract is designed to satisfy the Lenders’ requirements for bankability. EPC Contracts provide for:  A single point of responsibility – The Contractor is responsible for all design, engineering, procurement, construction, commissioning and testing activities. Therefore, if any problems occur the Project Company need only look to one party – The Contractor – To both fix the problem and provide compensation. As a result, if the Contractor is a consortium comprising several entities, the EPC Contract must state that those entities are jointly and severally liable to the Project Company  A fixed contract price – Risk of cost overruns and the benefit of any cost savings are to the Contractor’s account. The Contractor usually has a limited ability to claim additional money, which is limited to circumstances where the Project Company has delayed the Contractor or has ordered variations to the works  A fixed completion date – EPC Contracts include a guaranteed completion date that is either a fixed date or a fixed period after the commencement of the EPC Contract. If this date is not met the Contractor is liable for Delay Liquidated Damages (DLDs). DLDs are designed to compensate the Project Company for loss and damage suffered as a result of late completion of the facility. To be enforceable in common law jurisdictions, DLDs must be a genuine pre-estimate of the loss or damage that the Project Company will suffer if the facility is not completed by the target completion date. The genuine pre-estimate is determined by reference to the time the contract was entered into. DLDs are usually expressed as a rate per day, which represents the estimated extra costs incurred (such as extra insurance, supervision fees and financing charges) and losses suffered (revenue forgone) for each day of delay. In addition, the EPC Contract must provide for the Contractor to be granted an extension of time when it is delayed by the acts or omissions of the Project Company. The extension of time mechanism and reasons why it must be included are discussed below. Performance guarantees. The Project Company’s revenue will be earned by operating the facility. Therefore, it is vital that the wind farm or solar farm performs as required in terms of output and reliability. As such EPC Contracts contain performance guarantees backed by compensation measures such as Performance Liquidated Damages (PLDs), payable by the Contractor if it fails to meet the performance guarantees. These mechanisms are described in further detail below. PLDs must be a genuine pre-estimate of the loss and damage that the Project Company will suffer over the life of the project if the wind farm does not achieve the specified performance guarantees. As with DLDs, the genuine pre-estimate is determined by reference to the time the contract was signed. PLDs usually represent a net present value (NPV) (less expenses) calculation of the revenue forgone over the life of the project if the relevant performance guarantees are not met. PLDs and the performance guarantee regime and its interface with DLDs and the delay regime is discussed in more detail below. Caps on liability. As mentioned above, most EPC Contractors will not, as a matter of company policy, enter into contracts with unlimited liability. Therefore, EPC Contracts for power projects cap the Contractor’s liability at a percentage of the contract price. This varies from project to project; however, an overall liability cap of 100% of the contract price is common. In addition, there are normally sub-caps on the Contractor’s liquidated damages liability. For example, DLDs and PLDs might each be capped at 15% of the contract price, with an overall cap on both types of liquidated damages of 25% of the contract price. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 263 There will also generally be an exclusion of consequential or indirect loss. Put simply, consequential damages are those damages that do not flow directly from a breach of contract, but which were in the reasonable contemplation of the parties at the time the contract was entered into. This used to mean heads of damage like loss of profit. However, loss of profit is now usually recognised as a direct loss on project financed projects and, therefore, would be recoverable under a contract containing a standard exclusion of consequential loss clause. Given the unclear position under Australian law, parties must ensure that an exclusion of liability clause is carefully drafted. Importantly, the clause should set out clearly and exhaustively expressed in detail those losses which are intended to be categorised as consequential. Where presented with a clause excluding liability for consequential loss, project companies must expressly state the categories of loss for which the Contractor will be liable. This essentially means that project companies will need to include a definition of Direct Loss which would identify losses that are within the contemplation of the parties, (eg in a project financing of a power or process plant project a Direct Loss should include loss of revenue under a corresponding PPA). Clearly this may be difficult to negotiate, but this should nevertheless be the starting position. Nonetheless, care should be taken to state explicitly that liquidated damages can include elements of consequential damages. Given the rate of liquidated damages is pre-agreed, most Contractors will not object to this exception to the exclusion on consequential loss. In relation to both caps on liability and exclusion of liability, it is common for there to be some exceptions. The exceptions may apply to either or both the cap on liability and the prohibition on claiming consequential losses. The exceptions themselves are often project specific; however, some common examples include fraud or wilful misconduct, death or personal injury and breaches of intellectual property warranties. Security. It is standard for the Contractor to provide performance security to protect the Project Company if the Contractor does not comply with its obligations under the EPC Contract. The security takes a number of forms including:  A bank guarantee for a percentage, normally in the range of 5-15%, of the contract price. The actual percentage will depend on a number of factors including the other security available to the Project Company, the payment schedule (the greater the percentage of the contract price remaining unpaid by the Project Company at the time it is likely to draw on security to satisfy DLD and PLD obligations, the smaller the bank guarantee can be), the identity of the Contractor and the risk of it not properly performing its obligations, the price of the bank guarantee and the extent of the technology risk associated with the facility. the Project Company and the Lenders will generally require minimum standards in respect of the entity providing the guarantee, such as a minimum Standard & Poor's rating, and may also require the ability to approve the specific provider of the guarantee  Retention, ie withholding a percentage (usually 5%-10%) of each payment. Provision may be made to replace retention monies with a bank guarantee (sometimes referred to as a retention guarantee or retention bond). However, cash retention and retention guarantees/bonds are less prevalent in the current market as both project companies and Lenders prefer this to be incorporated into the bank guarantee  Advance payment guarantee, if an advance payment is made. This is generally in the form of a bank guarantee to the value of the advance payment  Parent company guarantee, from the ultimate parent (or other suitable related entity) of the Contractor, which provides that it will perform the Contractor's obligations if, for whatever reason, the Contractor does not perform. Variations. The Project Company has the right to order variations and agree to variations suggested by the Contractor. If the Project Company wants the right to either omit works in their entirety or to be able to engage a different Contractor, this must be stated specifically. In addition, a properly drafted variations clause should make provision for how the price of a variation is to be determined. In the event the parties do not reach agreement on the price of a variation, the Project Company or its representative should be able to determine the price. This determination is subject to the dispute resolution provisions. In addition, the variations clause should detail how the impact, if any, on the performance guarantees is to be treated. For some larger variations the Project Company may also wish to receive additional security. If so, this must also be specified within the variations clause. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 264 Defects liability. The Contractor is usually obliged to repair defects that occur in the 12 to 24 months following completion of performance testing. Defects liability clauses can be tiered, ie the clause can provide for one period for the entire facility and a second, extended period for more critical items (eg wind turbines or PV panels). In such cases, the Project Company will usually seek to ensure that it is protected by manufacturer’s warranties (discussed in further detail below). Intellectual property. The Contractor warrants that it has rights to all intellectual property used in the execution of the works and indemnifies the Project Company if any third parties’ intellectual property rights are infringed. Force majeure. The parties are excused from performing their obligations if a force majeure event occurs. This is discussed in more detail below. Suspension. The Project Company usually has the right to suspend the works. Termination. This sets out the contractual termination rights of both parties. The Contractor usually has very limited contractual termination rights. These rights are limited to the right to terminate for non-payment or for prolonged suspension or prolonged force majeure and will be further limited by the tripartite agreement between the Project Company, the Lenders and the Contractor. The Project Company will have more extensive contractual termination rights. They will usually include the ability to terminate immediately for certain major breaches or if the Contractor becomes insolvent and the right to terminate after a cure period for other breaches. In addition, the Project Company may have a right to terminate for convenience. It is likely the Project Company’s ability to exercise its termination rights will also be limited by the terms of the financing agreements. Performance specification. Unlike a traditional construction contract, an EPC Contract usually contains a performance specification. The performance specification details the performance criteria that the Contractor must meet. However, it does not dictate how such criteria must be met. This is left to the Contractor to determine. A delicate balance must be maintained. The specification must be detailed enough to ensure the Project Company knows what it is contracting to receive but not so detailed that if problems arise the Contractor can argue that the issues are not its responsibility. Potential drawbacks of using an EPC Contract Whilst there are, as described above, numerous advantages to using an EPC Contract, there are some disadvantages. These include the fact that an EPC Contract may command a higher contract price than alternative contractual structures. One factor is the allocation of almost all the construction risk to the Contractor. This has a number of consequences, one of which is that the Contractor will have to factor into its price the cost of absorbing those risks. This will result in the Contractor building contingencies into the contract price for events that are unforeseeable and/or unlikely to occur. If those contingencies were not included, the contract price would be lower. However, the Project Company would bear more of the risk of those unlikely or unforeseeable events, which may not be acceptable to the Lenders. Sponsors have to determine, in the context of their particular project, whether the strict risk allocation is warranted in the face of the increased price. As a result, Sponsors and their advisors must critically examine the risk allocation on every project. Risk allocation should not be an automatic process. Instead, the Project Company should allocate risk in a sophisticated way that delivers the most efficient result. For example, if a project is being undertaken in an area with unknown geology and without the time to undertake a proper geotechnical survey, the Project Company may be best served by bearing the site condition risk itself as it will mean the Contractor does not have to price a contingency it has no way of quantifying. This approach can lower the risk premium paid by the Project Company. Alternatively, the opposite may be true. The Project Company may wish to pay for the contingency in return for passing off the risk which quantifies and caps its exposure. This type of analysis must be undertaken on all major risks prior to going out to tender. Another consequence of this strict approach to risk allocation is the fact that there are relatively few construction companies that can and are willing to enter into EPC Contracts, which can also result in relatively high contract prices. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 265 Another major disadvantage of an EPC Contract becomes evident when problems occur during construction. In return for receiving a guaranteed price and a guaranteed completion date, the Project Company cedes most of the day-to-day control over the construction. Therefore, project companies have limited ability to intervene when problems occur during construction. The more a Project Company interferes, the greater the likelihood of the Contractor claiming additional time and costs. In addition, interference by the Project Company will make it substantially easier for Contractors to defeat claims for liquidated damages and defective works. Obviously, ensuring the project is completed satisfactorily is usually more important than protecting the integrity of the contractual structure. However, if a Project Company interferes with the execution of the works, in most circumstances it will have the worst of both worlds – A contract that exposes it to liability for time and costs incurred as a result of its interference without any corresponding ability to hold the Contractor liable for delays in completion or defective performance. The same problems occur even where the EPC Contract is drafted to give the Project Company the ability to intervene. In many circumstances, regardless of the actual drafting, if the Project Company becomes involved in determining how the Contractor executes the works, then the Contractor will be able to argue that it is not liable for either delayed or defective performance. It is critical that great care is taken in selecting a Contractor that has sufficient knowledge and expertise to execute the works. Given the significant monetary value of EPC Contracts, and the potential adverse consequences if problems occur during construction, the lowest price should not be the only factor. Split EPC Contracts One common variation on the basic EPC structure illustrated above is a split EPC Contract. In the case of wind and hydro projects, the split is commonly between the turbine supplier, responsible for supplying, installing and commissioning the turbines, and the civils Contractor responsible for performing the balance of the plant (BOP). Lower prices may be achieved using this form of split by avoiding the Contractor applying a risk premium for having to wrap or guarantee either equipment that it has not sourced or manufactured or works that it has not performed. Another common split structure involves splitting an EPC Contract into an onshore construction contract and an offshore supply contract28. The main reason for using this form of split contract is because it can result in a lower contract price as it allows (in an onshore/offshore split) the Contractor to make savings in relation to onshore taxes; in particular on indirect and corporate taxes in the onshore jurisdiction29 . In multi-jurisdiction projects, a split structure may also be used to reduce the cost of complying with local licensing regulations by having certain portions of the works, particularly the design works, undertaken in other offshore jurisdictions. In a split arrangement, unlike a standard EPC Contract, the Project Company cannot look only to a single Contractor to satisfy all the contractual obligations (in particular, design, construction and performance). In such cases a third agreement, a wrap-around guarantee or coordination and interface agreement, may be used to deliver a single point of responsibility despite the split. Under a wrap-around guarantee, an entity, usually either the offshore supplier or the parent company of the contracting entities, guarantees the obligations of both Contractors. This delivers a single point of responsibility to the Project Company and the Lenders. However, a wrap-around guarantee will not be relevant where the manufacturer of the turbines or panels and the balance of plant Contractor are separate entities and neither company will take the single point of responsibility under the wrap-around guarantee. Accordingly, the Lenders will want to be satisfied that the interface issues are dealt with in the absence of a single point of responsibility. 28 For a more detailed discussion on split EPC Contracts refer to the PwC’s International Best Practice in Project and Construction Agreements guide 29 This is common to projects in Asia; however, detailed tax advice is required to ascertain whether this is appropriate for any specific project. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 266 Key renewable energy specific clauses in EPC Contracts Manufacturers’ warranties Ensuring that the EPC Contract allows for recourse by the Project Company to the manufacturers’ warranties for equipment such as (in the case of solar PV) inverters, modules, trackers and other key components, is paramount to meeting bankability requirements. It is critical that the technology used for a facility is efficient, reliable, safe and serviceable. The solar PV manufacturing landscape in particular has seen many manufacturers face a zero or negative profit margins and file for bankruptcy due to the rapid growth of the market leading to an oversupply which has depressed prices. With most solar PV facilities expected to have a lifetime of 20+ years, the Owner needs to ensure that the manufacturer behind the inverters, modules and other warranted equipment it uses can honour the warranty for the life of the project. To avoid potential issues arising, we recommend that parties are stringent in conducting their due diligence regarding the selection of manufacturers. This includes looking for (among other things) common financial metrics to indicate the relative stability of those manufacturers (eg cash flow per share, debt to capital ratio). Key matters for consideration in reviewing any warranty offered by a manufacturer include:  Term of the warranty – Although the required term will vary depending on the equipment that the warranty applies to, the term must be sufficient to cover the likely period in which issues are likely to arise and (if possible) the life of the facility. For example, in the case of PV modules, these warranties should subsist for 5 to 10 years after the commercial operation date for product guarantees or defects, and up to 25 years in respect of output guarantees and degradation  What is covered by the warranty – Which piece of equipment and which level of performance? Are there any exclusions or exemptions? For example, if there is an over-sizing of the panel arrays in proportion to the inverters, will this void or otherwise affect the warranties provided in respect of the inverters  Choice of law – Manufacturers will generally select the law of the country in which their operations are based. However, inconsistencies may arise where this is different to the law applying to the other project documents. Manufacturer’s warranties may also be difficult to enforce in certain jurisdictions such as the People’s Republic of China  Dispute resolution – The warranty documents should set out the process to be followed in the event that a dispute arises. International manufacturers generally tend to prefer arbitration over litigation. The warranties obtained by the Contractor must be fully transferrable and contain provisions to be assigned to the Project Company on project completion or in the event of the Contractor’s default or insolvency. Further protections for the Project Company and the Lenders include the side agreements and Lenders’ ability to take security over the warranties and to exercise the right of step-in under a tripartite agreement. Where manufacturer’s warranties are not available, or where they are available but may be inadequate or impractical to enforce, Lenders and Sponsors may need to consider other options. One option we are seeing in the market to address the risk of under-performance are specialist insurance products that guarantee the output of the system. The cost of the long-term usage of such insurance products is something that would have to be weighed against other options and, if selected, incorporated into the project financial model. Another option to avoid over-reliance on manufacturer’s warranties is to implement stringent quality assurance practices for key components. This will generally involve a multi-stage process, including factory audits and field inspections, on-site inspections of purchased equipment before it leaves the plant and field inspections following installation. To maintain stringency, it is preferable that an independent QA is used rather than relying on any QA conducted by the manufacturer. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 267 Serial defects Where a facility incorporates a large number of the same components that are critical to performance (such as wind turbines for wind facilities or modules or inverters for solar PV facilities), it is important that the Sponsors are protected in the instance that a fault or defect emerges in a batch or other consignment of that component with the same root cause (known as a ‘serial defect’). Although Sponsors should also be protected by the manufacturer’s warranties applying to those components (as noted above), it is beneficial for bankability purposes to ensure that the Contractor also has obligations to address serial defects. Serial defects provisions are triggered where defects with the same root cause arise in respect a specified percentage of a batch or consignment of a component. Although the required percentage will vary depending on factors such as the technology used, we have seen ranges between 2-20% of a specific component. The term of the Contractor’s serial defects obligations will generally be the same length as the defects liability period. If a serial defect is identified, the Contractor will generally be required to test all other components from the same batch or consignment to determine whether the serial defect is present. An independent party or laboratory may be nominated in the EPC Contract to perform the tests if required. As a minimum, the Contractor will be required to report to the Sponsors on the result of the tests and to replace the components in which the serial defect is identified (at the cost of the Contractor, including shipping costs). Generally the Contractor will be required to replace all components within that batch or component (even those in which a serial defect was not identified in testing) to ensure that the serial defect does not arise elsewhere. A requirement may also be included to notify the Project Company in the event that serial defects are identified in other batches of the same product worldwide, in which case the Project Company may require additional monitoring to be implemented. Grid access Clearly, EPC Contracts will not provide for the handover of the wind farm or solar PV facility to the Project Company and the PPA will not become effective until all commissioning and reliability trialling has been successfully completed. This raises the important issue of the need for the EPC Contract to clearly define the obligations of the Project Company in providing grid access to the Contractor. Lenders need to be able to avoid the situation where the Project Company’s obligation to ensure grid access is uncertain, as this could result in protracted disputes concerning the Contractor’s ability to place load onto the grid system and to obtain extensions of time where delay has been caused as a result of the failure of the Project Company to provide grid access. Grid access issues arise at two differing levels, namely:  the obligation to ensure that the infrastructure is in place  the obligation to ensure that the Contractor is permitted to export power. With respect to the first obligation, the Project Company is the most appropriate party to bear this risk vis-à-vis the Contractor, since the Project Company usually either builds the infrastructure itself or has it provided through the relevant concession agreement. Issues that must be considered include:  What are the facilities that are to be constructed (eg substations, transmission lines) and how will these facilities interface with the Contractor’s works? Is the construction of these facilities covered by the PPA, connection agreement, concession agreement or any other construction agreement? If so, are the rights and obligations of the Project Company dealt with in a consistent manner?  What is the timing for completion of the infrastructure – Will it fit in with the timing under the EPC contract? With respect to the Contractor’s ability to export power, the EPC Contract must adequately deal with this risk and satisfactorily answer the following questions to ensure the smooth testing, commissioning and entering of commercial operation: Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 268  What is the extent of the grid access obligation? Is it merely an obligation to ensure that the infrastructure necessary for the export of power is in place or does it involve a guarantee that the grid will take all power which the Contractor wishes to produce?  What is the timing for the commencement of this obligation? Does the obligation cease at the relevant target date of completion? If not, does its nature change after the date has passed?  What is the obligation of the Project Company to provide grid access in cases where the Contractor's commissioning/plant is unreliable - Is it merely a reasonableness obligation?  Is the relevant grid robust enough to allow for full testing by the Contractor - For example, the performance of full load rejection testing?  What is the impact of relevant national grid codes or legislation and their interaction with both the EPC Contract and the PPA? Many EPC Contracts are silent on these matters or raise far more questions than they actually answer. It is advisable to back to back the Project Company’s obligations under the EPC Contract (usually to provide an extension of time and/or costs) with any restrictions under the PPA. This approach will not eliminate the risk associated with grid access issues but will make it more manageable. A variety of projects we have worked on have incurred significant amounts of time and costs in determining the grid access obligations under the EPC Contract, indicating that it is a matter which must be resolved at the contract formation stage. Therefore, we recommend inserting the clauses in Appendix 1, as modified to align with the relevant regulatory/grid access regime. Development and environmental considerations The responsibility for environmental obligations relating to the construction and operation of a wind or solar facility must be set out clearly in the EPC Contract. In particular, wind farms have a range of environmental impacts which need to be considered and managed properly and the Sponsor or Project Company will have to investigate if any aspects of the project are likely to be subject to scrutiny under the Environmental Protection and Biodiversity Conservation Act 1999 (Cth) (EPBC Act)30 or other environment or planning legislation such as the relevant state planning scheme provisions. Certain factors relating to the location of the facility or its effect on particular environmental features may limit development or trigger the need for reports or assessments to be conducted and approvals obtained before construction can proceed. For example, as outlined above, if wind turbines are located close to dwellings, written consent may be required from the Owners before development is allowed. Depending on the relevant state legislative framework, if the facility will require the clearance of native vegetation, a native vegetation offset management plan may need to be prepared, and if flora and fauna will be affected, surveys and assessments may be required. In the case of solar PV, issues may arise in respect of visual amenity and glint issues. In a recent decision Civil Aviation Safety Authority (CASA) rejected claims that potential glare from a proposed solar farm at Mt Majura in the ACT could pose a danger for aircraft using nearby Canberra Airport31 . Environmental and development impacts of solar and wind energy facilities include:  Concern regarding visual impact, as well as the effect of shadow flicker and blade glint (for wind) or reflective glare (solar), which must be avoided or mitigated by design and siting  Visual impacts may also pose an issue in terms of effects on particular locations of high amenity or tourist value, which may restrict or prevent development 30 The EPBC Act prescribes the Commonwealth’s involvement in environmental matters where an action has or will have a significant impact on “matters of national environmental significance”. Detailed administrative guidelines are found at www.environment.gov.au/epbc 31 Energy Business News, ‘Solar Glare Claims for Canberra Solar Rejected: CASA’, 15 November 2013 http://www.energybusinessnews.com.au/energy/solar/solar-glare-claims-for-canberra-solar-rejected-casa/ Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 269  In the case of wind, noise from the swishing of the blades and mechanical noise associated with noise from the generator, along with requirements to comply with prescribed noise standards and guidelines  Impacts on listed threatened species that inhabit the nearby area, whose habitat or surrounding ecological community may be impacted by the development, or on migratory species that may fly or move through the wind farm area, even if they do not inhabit the area. This is a particular issue in the case of migratory birds whose migration path crosses an established or proposed wind energy facility. In addition, effects on areas of high conservation and landscape values, such as national and state parks, Ramsar Wetlands, World Heritage properties and National Heritage Places, may also limit or prevent development  Effects caused by the clearance of native vegetation during construction and continued clearing requirements during the operation of the facility to, in the case of solar, avoid shading or shadowing  Potential electromagnetic interference with microwave, television and radio signals  Construction issues such as the impact of construction traffic and the construction of access road and laydown areas  Archaeological and heritage issues including the impact on cultural heritage values and sites of significance to Indigenous peoples. Many of these issues will be most relevant at the stage of seeking development approval and will be the responsibility of the Sponsor or Project Company. The list of permits, approvals and licences that must be obtained by the Project Company should be clearly identified in the EPC Contract, with the balance of construction consents and approvals being the responsibility of the Contractor. However, responsibility for adherence to the conditions attached to the development approvals, permits and the risks identified in the environmental impact assessment, must be passed on to the Contractor. For instance, planning approvals for wind farms are generally subject to permit conditions about noise limits. The Contractor must adhere to the required noise specifications and provide warranties that the wind farm will comply with the noise curves required by the specifications. If the environmental assessment has identified areas of ecological or archaeological importance, then these pre-construction site conditions must be documented in the EPC Contract and accepted by the Contractor. The Contractor must also develop an environmental management plan to identify risks, mitigation and monitoring processes during construction. This should take into account factors such as erosion, dust and sediment control, storage of hazardous materials, weed control and waste management. Consistency of commissioning and testing regimes It is also important to ensure the commissioning and testing regimes in the EPC Contract mirror the requirements for commercial operation under the PPA. Mismatches only result in delays, lost revenue and liability for damages under the PPA, all of which have the potential to cause disputes. Testing/trialling requirements under both contracts must provide the necessary Project Company satisfaction under the EPC Contract and system Operator/offtaker satisfaction under the PPA or connection agreement. Relevant testing issues which must be considered include:  Are differing tests/trialling required under the EPC Contract and the PPA/connection agreement? If so, are the differences manageable for the Project Company or likely to cause significant disruption?  Is there consistency between obtaining handover from the Contractor under the EPC Contract and commercial operation? It is imperative to prescribe back-to-back testing under the relevant PPA and the EPC Contract, which will result in a smoother progress of the testing and commissioning and better facilitate all necessary supervision and certification. Various certifications will also be required at the Lender level, and the Lenders will not want the process to be held up by their own requirements for certification. To avoid delays and disruption it is important that the Lenders' engineer is acquainted with the details of the project and, in particular, any potential difficulties with the testing regime. Therefore, any potential problems can be identified early and resolved without impacting on the commercial operation of the facility Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 270  Is the basis of the testing to be undertaken mirrored under both the EPC Contract and the PPA? For example, what noise tests are to be performed?  What measurement methodology is being used? Are there references to international standards or guidelines to a particular edition or version?  Are all tests necessary for the Contractor to complete under the EPC Contract able to be performed as a matter of practice? Significantly, if the relevant specifications are linked to guidelines such as the relevant International Electrotechnical Commission (IEC) standard, consideration must be given to changes which may occur in these guidelines. The EPC Contract reflects a snapshot of the standards existing at a time when that contract was signed, meaning that mismatches may occur if the relevant standards guidelines have changed. It is important that there is certainty as to which standard applies for both the PPA and the EPC Contract – The standard at the time of entering the EPC Contract or the standard which applies at the time of testing? Consideration must be given to the appropriate mechanism to deal with potential mismatches between the ongoing obligation of complying with laws, and the Contractor’s obligation to build to a specification agreed at a previous time. One solution is to require satisfaction of guidelines “as amended from time to time”. The breadth of any change of law provision will be at the forefront of any review. The above issues raise the importance of the testing schedules to the EPC Contract and the PPA. The size and importance of the various projects to be undertaken must mean that the days where schedules are attached at the last minute without being subject to review are gone. Discrepancies between the relevant testing and commissioning requirements will only serve to delay and distract all parties from the successful completion of testing and reliability trials. In addition, there is a need to ensure that the interface arrangements in relation to testing and commissioning are appropriately and clearly spelled out between the EPC Contractor and the Operator under the EPC Contract, the O&M contract and any other relevant interface agreements to avoid any subsequent interface disputes. These are all areas where lawyers can add value to the successful completion of projects by being alert to and dealing with such issues at the contract formation stage. Interface issues between the offtaker and the EPC Contractor It is imperative that the appropriate party corresponds with the relevant offtaker/system Operator during construction on issues such as the provision of transmission facilities/testing requirements and timing. The Project Company must ensure the EPC Contract states clearly that it is the appropriate party to correspond with the offtaker and the system Operator. Any uncertainty in the EPC Contract may unfortunately see the EPC Contractor dealing with the offtaker and/or the system Operator, possibly risking the relationship of the Project Company with its customer. It is the Project Company which must develop and nurture an ongoing and long term relationship with the offtaker, whereas the Contractor’s prime objective is generally to complete the project on time or earlier at a cost which provides it with significant profit. The clash of these conflicting objectives in many cases does not allow for such a smooth process. Again, the resolution of these issues at the EPC Contract formation stage is imperative. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 271 Interface issues on site access Access to land involves negotiations with the landowner or the appropriate state-based land authority. In the case of wind energy in particular, the Project Company will generally enter into access agreements with the landowners, and may be required to do so under legislation. The more common arrangements will be land leases providing possession and site access for the duration of the construction and operation of the wind farm. While the leasing of land to wind energy companies provides long-term income that complements farming income, the substance of the land lease agreements with landowners is the subject of much discussion and negotiation, Principally to ensure that the environmental and development impact of the wind farm development is considered and managed properly. Securing land rights for good development sites may be difficult if there is community opposition to these developments, particularly given controversy in recent years relating to aspects of wind farm development such as noise and “flicker” issues from wind turbines. However, there is also a large body of community support for wind farms demonstrated by pro-wind rallies and the increasing development of community wind farms such as Hepburn Wind32 . Principal responsibility for obtaining access to the site and negotiating the terms of the lease agreements will lie with the Project Company. However, in order for the Project Company to comply with the terms of the land lease or other access agreements, the Project Company will have to ensure that the Contractor under the EPC Contract complies with all the terms and conditions of the land lease agreements. The Contractor must also accept some degree of responsibility for the ongoing liaison and coordination with landowners during the construction and operation of the facility. Given that considerations and concerns will often differ between landowners, the specific requirements of the landowners should be taken into account at an early stage in the negotiation of the terms of the EPC Contract for any facility. Such concerns will vary from prohibitions on the depth of excavation to allow farming activity, to controlling the spread of pests and weeds. The Project Company should only be required to provide possession and access as permitted under the negotiated land lease or site agreements, and the obligations of the Project Company under the land lease or site agreements should be flowed down into the EPC Contract. The Contractor should be appraised of the specific conditions and requirements of the landowners to ensure that the Contractor is aware of the limits on access to the site on which the facility is to be constructed and operated. The Contractor must formally acknowledge the Project Company’s obligation to comply with the terms of the land lease or site agreements and must accept responsibility for compliance with the terms of the land lease or site agreements which are affected by the Contractor’s design and construction obligations under the EPC Contract. The Project Company should only be required to provide possession and access as permitted under the negotiated land lease or site agreements, and the obligations of the Project Company under the land lease or site agreements should be flowed down into the EPC Contract. The Contractor should be appraised of the specific conditions and requirements of the landowners to ensure that the Contractor is aware of the limits on access to the site on which the facility is to be constructed and operated. The Contractor must formally acknowledge the Project Company’s obligation to comply with the terms of the land lease or site agreements and must accept responsibility for compliance with the terms of the land lease or site agreements which are affected by the Contractor’s design and construction obligations under the EPC Contract. Wind turbine certification In the case of wind farms, the provision of design certificates or a statement of compliance from an independent certifying body is essential for the Project Company to ensure that the wind turbines provided by the Contractor have been designed in accordance with industry standards and will fulfil the required design parameters. 32 Hepburn Wind is a 4.1 MW community owned wind energy facility, located at Leonards Hills in Victoria and reached commercial operation in July 2011: http://hepburnwind.com.au/the-project/ Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 272 Certification of wind turbines has a history of more than 25 years and different standards apply in Denmark, Germany and the Netherlands (which pioneered the development and application of certification rules). In recent years, other countries, as well as Lenders, have realised the necessity of a thorough evaluation and certification of wind turbines and their proposed installation. The certifications are commonly divided into type certification and wind turbine certification. The certification is usually required to be carried out by an independent certifying body such as Germanischer Lloyd Industrial Services GmbH (GL Renewables) (an international operating certification body for renewable energy equipment, including wind turbines), and is performed in accordance with that body’s rules – In the case of GL Renewables in accordance with the Regulations for the Certification of Wind Energy Conversion Systems, 1999 edition and the Guideline for the Certification of Wind Turbines, 2010 edition33 . Under these regulations, type certification comprises design assessment, evaluation of quality management and prototype testing and is preferably obtained by the Project Company prior to shipment of components to site. Where possible, the certification should encompass confirmation on the design life of the wind turbines. Wind turbine certification involves a complete third party assessment and certification of specific wind turbines from design assessment to commissioning, witnessing, site assessment and periodic monitoring. Wind turbine certification can only be carried out for type certified wind turbines and on locations for which the necessary data is available. The Project Company may also require a site certification to be provided by an independent certifying body confirming that real site conditions of the wind farm as a whole (including factors such a wind, climate, topography and turbine layout) complies with the design parameters of the relevant international standard. The real climatic conditions of the relevant site will be provided to the certifying body for assessment of factors such as the wind conditions prevalent at the site as compared with standard wind conditions and the calculation of loads for the site conditions compared with the design basis. Staged completion As each wind turbine generator or solar PV array is usually constructed sequentially, they may be taken over by the Project Company as they each pass the required tests on completion. While the taking over of each wind turbine generator or solar PV array and associated equipment as and when it is installed and commissioned is not unusual, it is important to ensure that the issue of a taking over certificate for each individual wind turbine does not affect the Contractor’s obligations under the EPC Contract. Issues such as the management of staggered defects liability periods, the method of calculation of the availability guarantees and the point at which performance security held by the Project Company should be released are among the important issues that must be considered carefully by the Project Company when contemplating staged taking over. Despite taking over individual wind turbine generators or solar PV arrays, the performance security held by the Project Company should only be reduced or released when the facility has passed all tests required for commercial operation of the entire facility. Factors such as the time period between taking over of each wind turbine generator or solar PV array and the generation of electricity by the wind turbine generators or solar PV arrays taken over by the Project Company, will influence the point at which it is reasonable to reduce the performance security held by the Project Company. If the operation and maintenance obligations of an Operator of the facility commences on the taking over each wind turbine generator or solar PV array, the performance security to be provided by the Operator can be increased in accordance with the number of wind turbine generators or solar PV arrays taken over. The issue of a taking over certificate for individual wind turbine generators or solar PV arrays will also trigger commencement of the defects liability period for that particular wind turbine generator or solar PV array. If a facility has, in the case of a wind farm, between 20 and 25 wind turbines, this could mean that the Project Company will have to administer defects liability periods equivalent to the number of wind turbines on the wind farm. If there is a substantial gap between taking over of the first wind turbine and the last wind turbine, this could also result in the defects liability period for the first wind turbine expiring substantially earlier than the last wind turbine taken over and could affect the Contractor’s defects rectification or warranty obligations for 33 Other certifications include certification according to the Dutch prestandard NVN 11400-0, Wind Turbines – Part 0: Criteria for type certification-technical criteria”, Issue April 1999 and certification according to the Danish Technical Criteria. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 273 defects affecting the entire wind farm. The ideal position would be to require the defects liability period to commence on taking over of each wind turbine generator but to expire only from a set time from taking over of the entire wind farm. If this proves too onerous for the Contractor, the wind turbine generators could be divided into circuits, each comprising a separable portion. A taking over certificate will therefore only be issued in relation to each circuit, making it easier to administer the defects liability periods or to manage other issues such as the reduction of security. Another important consideration is to ensure that the delay liquidated damages imposed for failure to complete the entire facility by the required date for practical completion takes into account any revenue that may be generated by the Project Company from individual wind turbine generators or solar PV arrays that are taken over and operated prior to commercial operation of the entire facility. This is to ensure that the delay liquidated damages represent a genuine pre-estimate of the Project Company’s loss. Key performance clauses in renewable energy EPC Contracts Liquidated damages Almost every construction contract will impose liquidated damages for delay and standards in relation to the quality of construction. Most, however, do not impose PLDs. EPC Contracts impose PLDs because the achievement of the performance guarantees has a significant impact on the ultimate success of a project. Similarly, it is important that the wind farm or solar PV facility commences operation on time because of the impact on the success of the project and because of the liability the Project Company will have under other agreements (eg under a PPA or financing agreements). This is why DLDs are imposed. DLDs and PLDs are both “sticks” used to motivate the Contractor to fulfil its contractual obligations. The law of liquidated damages As discussed above, liquidated damages must be a genuine pre-estimate of the Project Company’s loss. If liquidated damages are more than a genuine pre-estimate they will be deemed to be a penalty and unenforceable. There is no legal sanction for setting a liquidated damages rate below that of a genuine preestimate, however, there are the obvious financial consequences. In addition to being unenforceable as a penalty, liquidated damages can also be void for uncertainty or unenforceable because they breach the Prevention Principle. ‘Void for uncertainty’ means, as the term suggests, that it is not possible to determine how the liquidated damages provisions work. In those circumstances, a court will void the liquidated damages provisions. The Prevention Principle was developed by the courts to prevent Employers, ie project companies, from delaying Contractors and then claiming DLDs. It is discussed in more detail below in the context of extensions of time. Prior to discussing the correct drafting of liquidated damages clauses to ensure they are not void or unenforceable it is worth considering the consequences of an invalid liquidated damages regime. If the EPC Contract contains an exclusive remedies clause the result is simple – The Contractor will have escaped liability unless the contract contains a ‘fail safe’ clause with an explicit right to claim damages at law if the liquidated damages regime fails. If, however, the EPC Contract does not contain an exclusive remedies clause the non-challenging party should be able to claim at law for damages they have suffered as a result of the challenging party’s non or defective performance. What then is the impact of the caps in the now invalidated liquidated damages clauses? Unfortunately, the position is unclear in common law jurisdictions, and a definitive answer cannot be provided based upon the current state of authority. It appears the answer varies depending upon whether the clause is invalidated due to its character as a penalty, or because of uncertainty or unenforceability. Our view of the current position is set out below. We note that whilst the legal position is not settled the position presented below does appear logical. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 274  Clause invalidated as a penalty – When liquidated damages are invalidated because they are a penalty (ie they do not represent a genuine pre-estimate of loss), the liquidated damages or its cap will not act as a cap on damages claims at general law. We note that it is rare for a court to find liquidated damages are penalties in contracts between two sophisticated, well-advised parties  Clause invalidated due to acts of prevention by the Principal – If a liquidated damage clause is invalidated as a result of the Contractor not being entitled to an extension of time for an act of prevention by the Principal, the amount of liquidated damages or the cap on liquidated damages specified in the EPC Contract will not act as a cap or limit in respect of general damage claims at law  Clause void for uncertainty – A liquidated damages clause that is unworkable or too uncertain to ascertain what the parties intended is severed from the EPC Contract in its entirety, and will not act as a cap on the damages recoverable by the Principal from the Contractor at law. Upon severance, the clause is, for the purposes of contractual interpretation, ignored. However, it should be noted that the threshold test for rendering a clause void for uncertainty is high, and courts are reluctant to hold that the terms of a contract, in particular a commercial contract where performance is well advanced, are uncertain. Drafting of liquidated damages clauses Given the role liquidated damages play in ensuring EPC Contracts are bankable, and the consequences detailed above of the regime not being effective, it is vital to ensure they are properly drafted to ensure Contractors cannot avoid their liquidated damages liability on a legal technicality. Therefore, it is important, from a legal perspective, to ensure DLDs and PLDs are dealt with separately. If a combined liquidated damages amount is levied for late completion of the works, it risks being struck out as a penalty because it will overcompensate the Project Company. However, a combined liquidated damages amount levied for underperformance may under compensate the Project Company. Our experience shows that there is a greater likelihood of delayed completion than there is of permanent underperformance. One of the reasons why projects are not completed on time is Contractors are often faced with remedying performance problems. This means, from a legal perspective, if there is a combination of DLDs and PLDs, the liquidated damages rate should include more of the characteristics of DLDs to protect against the risk of the liquidated damages being found to be a penalty. If a combined liquidated damages amount includes a NPV or performance element, the Contractor will be able to argue that the liquidated damages are not a genuine pre-estimate of loss when liquidated damages are levied for late completion only. However, if the combined liquidated damages calculation takes on more of the characteristics of DLDs the Project Company will not be properly compensated if there is permanent underperformance. It is also important to differentiate between the different types of PLDs to protect the Project Company against arguments by the Contractor that the PLDs constitute a penalty. For example, if a single PLDs rate is only focused on availability and not efficiency, problems and uncertainties will arise if the availability guarantee is met but one or more of the efficiency guarantees are not. In these circumstances, the Contractor will argue that the PLDs constitute a penalty because the loss the Project Company suffers if the efficiency guarantees are not met are usually smaller than if the availability guarantees are not met. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 275 Drafting of the testing, performance guarantee and compensation regime A properly drafted performance testing and guarantee regime is critical because the success or failure of the project depends, all other things being equal, on the performance of (ie revenue generated by) the wind farm or solar farm. The major elements of the performance regime are:  Testing  Performance Guarantees  Performance Liquidated Damages or other compensation measures. These are discussed in turn below. These are discussed in turn below. Testing Performance tests may cover a range of areas. Three of the most common are: Functional tests – These test the functionality of certain parts or components of the facility, rather than the facility as a whole. For example, in the case of wind farms, tests may be in relation to SCADA systems, power collection systems and meteorological masts, etc. Performance liquidated damages and other compensation measures do not normally attach to these tests; they are absolute obligations that must be achieved in order to reach the next stage of completion. Various components of the wind turbine generators themselves (including blades, hubs and nacelles) will also be subject to functional tests. In the case of solar PV, key components to be tested are panels, inverters, trackers (if used) and transformers. Performance guarantee tests – These test the ability of the facility to meet the performance guarantees for the facility specified in the contract. Performance tests and corresponding performance guarantees vary between technologies. Common across most renewable energy technologies is a two stage performance testing framework. The first round of performance tests is generally performed in order to achieve commercial operation and a second round (and potentially further subsequent rounds) is performed after the facility has been operating for a period of time. For wind farms, tests on commercial operation will generally be comprised of a commissioning test with a reliability run of around 240 hours (though this may vary by project). A capacity or output test and corresponding guarantee may be provided, depending on (among other factors) the requirements of the PPA or other concession arrangements. Tests after commercial operation generally include a range of acoustic tests and power curve tests. Power curve tests are generally performed 12-18 months after commercial operation; however, the time and expense of the performing the power curve test means that it will generally only be performed if the facility is experiencing performance issues. For solar PV farms, performance tests on commercial operation may include both capacity and performance ratio tests. Capacity tests may be in respect of installed capacity (measuring the aggregate nameplate DC capacity of all panels installed) and/or output or achieved capacity (measuring the aggregate DC capacity of the panels based on peak hourly conditions and net of auto-consumption and other system losses applicable under these conditions). Performance ratio tests (measuring the efficiency of the facility) will also generally be performed on commercial operation after an evaluation period of around 60 days. Tests after commercial operation are usually performance ratio tests and are generally completed over multiple 12 month evaluation periods corresponding with the duration of the defects liability period. In respect of the pre-commercial operation performance tests, the Contractor will continue to be liable for DLDs until either the facility achieves the guaranteed level or the Contractor pays compensation (such as PLDs) where the facility does not operate at the guaranteed level. Obviously, DLDs will be capped (usually at 15% of the contract price), therefore the EPC Contract should give the Project Company the right to call for the payment of the compensation and accept the facility. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 276 It is common for the Contractor to be given an opportunity to modify the facility if it does not meet the performance guarantees on the first attempt. This is because the compensation amounts are normally very large and most Contractors would prefer to spend the time and the money necessary to remedy performance instead of paying compensation. Not giving Contractors this opportunity will likely lead to an increased contract price both because Contractors will build a contingency for paying compensation into the contract price. Also, in most circumstances the Project Company will prefer to receive a facility that achieves the required performance guarantees. If the Contractor is to be given an opportunity to modify and retest, the EPC Contract must deal with who bears the costs required to undertake the retesting. The cost of the performance of a power curve test in particular can be significant and should generally be to the Contractor’s account because the retesting only occurs if the performance guarantees are not met at the first attempt. For each performance test, a corresponding performance guarantee will be set. This may be an absolute level (eg due to a corresponding regulatory requirement) or a percentage of the performance level to be reached. If the minimum performance guarantees are not met the Project Company will generally (subject to the requirements of any tripartite arrangements) have the right to terminate and may have the right to reject the facility and require the Contractor to dismantle the facility and return the site to a greenfield state. The level at which performance guarantees (including minimum performance guarantees) are set will depend on a variety of factors such as technical and project-specific considerations. The performance guarantees should be set at a level of performance at which it is economic to accept the facility. Lender’s input will be vital in determining what this level is. However, it must be remembered that Lenders have different interests to the Sponsors. Lenders will, generally speaking, be prepared to accept a facility that provides sufficient income to service the debt. However, in addition to covering the debt service obligations, Sponsors will also want to receive a return on their equity investment. If that will not be provided via the sale of electricity because the Contractor has not met the performance guarantees, the Sponsors will have to rely on the compensation mechanisms to earn their return. If the Contractor fails to achieve any of the required performance guarantees, the facility may not be able to generate energy at the rate included in the financial model and, as such, there will be a revenue shortfall. To ensure that the required ratios and covenants are met under the financing agreements, as well as to provide an equity return to the Sponsors, an EPC Contract will generally provide compensation mechanisms such as performance liquidated damages or a reduction in the contract price. A lump sum reduction in the contract price or ‘buy down’ is commonly used where the facility does not meet its capacity guarantees, and will be set at a level to reflect the NPV of the Project Company’s losses over the life of the facility due to lost production. Further commentary in respect of PLDs is set out above. If performance guarantees on commercial operation are not met and a reduction in the contract price and/or PLDs are paid by the Contractor, there will be an adjustment made to the level of post-commercial operation performance guarantees and compensation measures to ensure that the Project Company does not ‘double recover’ for the same loss. A diagram setting out a sample performance testing and performance guarantee framework for solar PV is set out at Appendix 1. Technical issues Ideally, the technical testing procedures should be set out in the EPC Contract. However, for a number of reasons, including the fact that it is often not possible to fully scope the testing program until the detailed design is complete, the testing procedures may be left to be agreed during construction by the Contractor, the Project Company’s representative or engineer and, if relevant, the Lenders’ engineer. However, a properly drafted EPC Contract should include the guidelines for testing. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 277 The complete testing procedures must, as a minimum, set out details of:  Testing methodology – Reference is often made to standard methodologies, for example, the IEC 61-400 methodology34  Testing equipment – Who is to provide it, where it is to be located, how sensitive must it be  Tolerances – What is the margin of error. For instance excluding wind or solar irradiance in excess of specified speeds or levels  Ambient conditions – What atmospheric conditions are assumed to be the base case (testing results will need to be adjusted to take into account any variance from these ambient conditions). Key general clauses in EPC Contracts Delay and extensions of time (a) The Prevention Principle As noted previously, one of the advantages of an EPC Contract is that it provides the Project Company with a fixed completion date. If the Contractor fails to complete the works by the required date they are liable to pay DLDs. However, in some circumstances the Contractor is entitled to an extension of the date for completion. Failure to grant an extension of time for a Project Company caused delay can void the liquidated damages regime and “set time at large”. This means the Contractor is only obliged to complete the works within a reasonable time. This is the situation under common law governed contracts due to the Prevention Principle. The Prevention Principle was developed by the courts to prevent Employers (ie project companies) from delaying Contractors and then claiming DLDs. The legal basis of the Prevention Principle is unclear and it is uncertain whether you can contract out of the Prevention Principle. Logically, given most commentators believe that given the Prevention Principle is an equitable principle, explicit words in a contract should be able to override the principle. However, the courts have tended to apply the Prevention Principle even in circumstances where it would not, on the face of it, appear to apply. Therefore, there is a certain amount of risk involved in trying to contract out of the Prevention Principle. The more prudent and common approach is to accept the existence of the Prevention Principle and provide for it the EPC Contract. The Contractor’s entitlement to an extension of time is not absolute. It is possible to limit the Contractor’s rights and impose pre-conditions on the ability of the Contractor to claim an extension of time. A relatively standard Extension of Time (EOT) clause would entitle the Contractor to an EOT for any of the following events:  An act, omission, breach or default of the Project Company  Suspension of the works by the Project Company (except where the suspension is due to an act or omission of the Contractor)  A variation (except where the variation is due to an act or omission of the Contractor) 34 The IEC (http://www.iec.ch/home-e.htm) is a global organisation that prepares and publishes international standards for all electrical, electronic and related technologies. The main technical committee for wind turbine systems is TC88 which publishes standards for the wind turbine industry. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 278 Force majeure Which cause a delay to an activity on the critical path and about which the Contractor has given notice within the period specified in the contract. It is permissible (and advisable) from the Project Company’s perspective to make both the necessity for the delay to impact the critical path and the obligation to give notice of a claim for an extension of time conditions precedent to the Contractor’s entitlement to receive an EOT. In addition, it is usually good practice to include a general right for the Project Company to grant an EOT at any time. However, this type of provision must be carefully drafted because some judges have held (especially when the Project Company’s representative is an independent third party) then the inclusion of this clause imposes a mandatory obligation on the Project Company to grant an extension of time whenever it is fair and reasonable to do so, regardless of the strict contractual requirements. Accordingly, from the Project Company’s perspective it must be made clear that the Project Company has complete and absolute discretion to grant an EOT, and that it is not required to exercise its discretion for the benefit of the Contractor. Similarly, following some recent common law decisions, the Contractor should warrant that it will comply with the notice provisions that are conditions precedent to its right to be granted an EOT. We recommend using the clause in Appendix 1. (b) Concurrent delay You will note that in the suggested EOT clause, one of the subclauses refers to concurrent delays. This is relatively unusual because most EPC Contracts are silent on this issue. For the reasons explained below we do not agree with that approach. A concurrent delay occurs when two or more causes of delay overlap. It is important to note that it is the overlapping of the causes of the delays, not the overlapping of the delays themselves that leads to concurrent delay. In our experience, this distinction is often not made. This leads to confusion and sometimes disputes. More problematic is when the contract is silent on the issue of concurrent delay and the parties assume the silence operates to their benefit. As a result of conflicting case law it is difficult to determine who, in a particular factual scenario, is correct. This can also lead to protracted disputes and outcomes contrary to the intention of the parties. There are a number of different causes of delay which may overlap with delay caused by the Contractor. The most obvious causes are the acts or omissions of a Project Company. A Project Company often has obligations to provide certain materials or infrastructure to enable the Contractor to complete the works. The timing for the provision of that material or infrastructure (and the consequences for failing to provide it) can be affected by a concurrent delay. For example, the Project Company is usually obliged, as between the Project Company and the Contractor, to provide a transmission line to connect to the wind farm by the time the Contractor is ready to commission the wind farm. Given the construction of the transmission line can be expensive, the Project Company is likely to want to incur that expense as close as possible to the date commissioning is due to commence. For this reason, if the Contractor is in delay the Project Company is likely to further delay incurring the expense of building the transmission line. In the absence of a concurrent delay clause, this action by the Project Company, in response to the Contractor’s delay, could entitle the Contractor to an extension of time. Concurrent delay is dealt with differently in the various international standard forms of contract. Accordingly, it is not possible to argue that one approach is definitely right and one is definitely wrong. In fact, the ‘right’ approach will depend on which side of the table you are sitting. In general, there are three main approaches for dealing with the issue of concurrent delay. These are:  Option One – The Contractor has no entitlement to an extension of time if a concurrent delay occurs  Option Two – The Contractor has an entitlement to an extension of time if a concurrent delay occurs  Option Three – The causes of delay are apportioned between the parties and the Contractor receives an extension of time equal to the apportionment. For example, if the causes of a 10-day-delay are apportioned 60:40 Project Company:Contractor, the Contractor would receive a six-day extension of time. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 279 Each of these approaches is discussed in more detail below. (i) Option One: Contractor not entitled to an extension of time for concurrent delays. A common, Project Company friendly, concurrent delay clause for this option one is: “If more than one event causes concurrent delays and the cause of at least one of those events, but not all of them, is a cause of delay which would not entitle the Contractor to an extension of time under [EOT Clause], then to the extent of the concurrency, the Contractor will not be entitled to an extension of time.” The most relevant words are bolded. Nothing in the clause prevents the Contractor from claiming an extension of time under the general extension of time clause. What the clause does do is to remove the Contractor’s entitlement to an extension of time when there are two or more causes of delay and at least one of those causes would not entitle the Contractor to an extension of time under the general extension of time clause. For example, if the Contractor’s personnel were on strike and during that strike the Project Company failed to approve drawings, in accordance with the contractual procedures, the Contractor would not be entitled to an extension of time for the delay caused by the Project Company’s failure to approve the drawings. The operation of this clause is best illustrated diagrammatically. Example 1: Contractor not entitled to an extension of time for Project Company caused delay In this example, the Contractor would not be entitled to any extension of time because the Contractor Delay 2 overlap entirely the Project Company Delay. Therefore, using the example clause above, the Contractor is not entitled to an extension of time to the extent of the concurrency. As a result, at the end of the Contractor Delay 2 the Contractor would be in eight-week delay (assuming the Contractor has not, at its own cost and expense accelerated the works). Example 2: Contractor entitled to an extension of time for a portion of the Project Company caused delay 6 weeks Contractor Delay 1 Project Company Delay 1 week 2 weeks 6 Weeks Contractor Delay Event Project Company Delay Event 2 WeeksDelay Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 280 In this example, there is no overlap between the Contractor and Project Company delay events and the Contractor would be entitled to a two-week extension of time for the Project Company delay. Therefore, at the end of the Project Company delay the Contractor will remain in six weeks delay, assuming no acceleration. Example 3: Contractor entitled to an extension of time for a portion of the Project Company caused delay In this example, the Contractor would be entitled to a one week extension of time because the delays overlap for one week. Therefore, the Contractor is entitled to an extension of time for the period when they do not overlap (ie when the extent of the concurrency is zero). As a result, after receiving the one-week extension of time, the Contractor would be in seven weeks delay, assuming no acceleration. From a Project Company’s perspective, we believe, this option is both logical and fair. For example, if, in example 2 the Project Company delay was a delay in the approval of drawings and the Contractor delay was the entire workforce being on strike, what logic is there in the Contractor receiving an extension of time? The delay in approving drawings does not actually delay the works because the Contractor could not have used the drawings given its workforce was on strike. In this example, the Contractor would suffer no detriment from not receiving an extension of time. However, if the Contractor did receive an extension of time it would effectively receive a windfall gain. The greater number of obligations the Project Company has the more reluctant the Contractor will likely be to accept option one. Therefore, it may not be appropriate for all projects. (ii) Option Two: Contractor entitled to an extension of time for concurrent delays Option two is the opposite of option one and is the position in many of the Contractor friendly standard forms of contract. These contracts also commonly include extension of time provisions to the effect that the Contractor is entitled to an extension of time for any cause beyond its reasonable control which, in effect, means there is no need for a concurrent delay clause. The suitability of this option will obviously depend on which side of the table you are sitting. This option is less common than option one but is nonetheless sometimes adopted. It is especially common when the Contractor has a superior bargaining position. (iii) Option Three: Responsibility for concurrent delays is apportioned between the parties Option three is a middle ground position that has been adopted in some of the standard form contracts. For example, the Australian Standards construction contract AS4000 adopts the apportionment approach. The AS4000 clause states: “34.4 Assessment When both non qualifying and qualifying causes of delay overlap, the Superintendent shall apportion the resulting delay to WUC according to the respective causes’ contribution. 6 Weeks Contractor Delay 1 Project Company Delay 2 weeks 2 weeks Contractor Delay 2 Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 281 In assessing each EOT the Superintendent shall disregard questions of whether: a) WUC can nevertheless reach practical completion without an EOT b) the Contractor can accelerate, but shall have regard to what prevention and mitigation of the delay has not been effected by the Contractor.” We appreciate the intention behind the clause and the desire for both parties to share responsibility for the delays they cause. However, we have some concerns about this clause and the practicality of the apportionment approach in general. It is easiest to demonstrate our concerns with an extreme example. For example, what if the qualifying cause of delay was the Project Company’s inability to provide access to the site and the nonqualifying cause of delay was the Contractor’s inability to commence the works because it had been black banned by the unions. How should the causes be apportioned? In this example, the two causes are both 100% responsible for the delay. In our view, an example like the above where both parties are at fault has two possible outcomes. Either:  The delay is split down the middle and the Contractor receives 50% of the delay as an extension of time  The delay is apportioned 100% to the Project Company and therefore the Contractor receives 100% of the time claimed. The delay is unlikely to be apportioned 100% to the Contractor because a judge or arbitrator will likely feel that that is “unfair”, especially if there is a potential for significant liquidated damages liability. We appreciate the above is not particularly rigorous legal reasoning, however, the clause does not lend itself to rigorous analysis. In addition, option three is only likely to be suitable if the party undertaking the apportionment is independent from both the Project Company and the Contractor. Exclusive remedies and fail safe clauses It is common for Contractors to request the inclusion of an exclusive remedies clause in an EPC Contract. However, from the perspective of a Project Company, the danger of an exclusive remedies clause is that it prevents the Project Company from recovering any type of damages not specifically provided for in the EPC Contract. An EPC Contract is conclusive evidence of the agreement between the parties to that contract. If a party clearly and unambiguously agrees that their only remedies are those within the EPC Contract, they will be bound by those terms. However, the courts have been reluctant to come to this conclusion without clear evidence of an intention of the parties to the EPC Contract to contract out of their legal rights. This means if the common law right to sue for breach of EPC Contract is to be contractually removed, it must be done by very clear words. (a) Contractor’s perspective The main reason for a Contractor insisting on a Project Company being subject to an exclusive remedies clause is to have certainty about its potential liabilities. The preferred position for a Contractor will be to confine its liabilities to what is specified in the EPC Contract. For example, an agreed rate of liquidated damages for delay and, where relevant, underperformance of the wind farm. A Contractor will also generally require the amount of liquidated damages to be subject to a cap and for the EPC Contract to include an overall cap on its liability. (b) Project company’s perspective The preferred position for a Project Company is for it not to be subject to an exclusive remedies clause. An exclusive remedies clause limits the Project Company’s right to recover for any failure of the Contractor to fulfil its contractual obligations to those remedies specified in the EPC Contract. For this reason, an exclusive remedies clause is an illogical clause to include in an EPC Contract from the perspective of a Project Company because it means that the Project Company has to draft a remedy or exception for each obligation – This represents an absurd drafting position. For example, take the situation where the EPC Contract does not have any provision for the recovery of damages other than liquidated damages. In this case, if the Contractor has either paid the maximum amount of liquidated damages or delivered the wind farm in a manner that does not require the payment of liquidated damages (ie it is delivered on time and performs to specification) but subsequent to that delivery the Project Company is found to have a claim, say for defective design which Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 282 manifests itself after completion, the Project Company will have no entitlement to recover any form of damages as any remedy for latent defects has been excluded. The problem is exacerbated because most claims made by a Project Company will in some way relate to performance of the facility and PLDs were expressed to be the exclusive remedy for any failure of the facility to perform in the required manner. For example, any determination as to whether the facility is fit for purpose will necessarily depend on the level and standard of the performance of the facility. In addition to claims relating to fitness for purpose, a Project Company may also wish to make claims for, amongst other things, breach of contract, breach of warranty or negligence. The most significant risk for a Project Company in an EPC Contract is where there is an exclusive remedies clause and the only remedies for delay and underperformance are liquidated damages. If, for whatever reason, the liquidated damages regimes are held to be invalid, the Project Company would have no recourse against the Contractor as it would be prevented from recovering general damages at law, and the Contractor would escape liability for late delivery and underperformance of the facility. (c) Fail safe clauses In contracts containing an exclusive remedies clause, the Project Company must ensure all necessary exceptions are expressly included in the EPC Contract. In addition, drafting must be included to allow the Project Company to recover general damages at law for delay and underperformance if the liquidated damages regimes in the EPC Contract are held to be invalid. To protect the position of a Project Company (if liquidated damages are found for any reason to be unenforceable and there is an exclusive remedies clause), we recommend the following clauses be included in the EPC Contract: “[ ].1 If clause [delay liquidated damages] is found for any reason to be void, invalid or otherwise inoperative so as to disentitle the Project company from claiming Delay Liquidated Damages, the Project company is entitled to claim against the Contractor damages at law for the Contractor’s failure to complete the Works by the Date for Practical Completion. [ ].2 If [ ].1 applies, the damages claimed by the Project company must not exceed the amount specified in Item [ ] of Appendix [ ] for any one day of delay and in aggregate must not exceed the percentage of the EPC Contract Price specified in Item [ ] of Appendix [ ].” These clauses (which would also apply to PLDs) mean that if liquidated damages are held to be unenforceable for any reason the Project Company will not be prevented from recovering general damages at law. However, the amount of damages recoverable at law may be limited to the amount of liquidated damages that would have been recoverable by the Project Company under the EPC Contract if the liquidated damages regime had not been held to be invalid (see discussion above). For this reason, the suggested drafting should be commercially acceptable to a Contractor as its liability for delay and underperformance will be the same as originally contemplated by the parties at the time of entering into the EPC Contract. In addition, if the EPC Contract excludes the parties’ rights to claim their consequential or indirect losses, these clauses should be an exception to that exclusion. The rationale being that the rates of liquidated damages are likely to include an element of consequential or indirect losses. Force Majeure (a) What is force majeure? Force majeure clauses are almost always included in EPC Contracts. However, they are rarely given much thought unless and until one or more parties seek to rely on them. Generally, the assumption appears to be that “the risk will not affect us” or “the force majeure clause is a legal necessity and does not impact on our risk allocation under the contract”. Both of these assumptions are inherently dangerous, and, particularly in the second case, incorrect. Therefore, especially in the current global environment, it is appropriate to examine their application. Force majeure is a civil law concept that has no real meaning under the common law. However, force majeure clauses are used in contracts because the only similar common law concept – The doctrine of frustration – Is of limited application. For that doctrine to apply the performance of a contract must be radically different from what was intended by the parties. In addition, even if the doctrine does apply, the consequences are unlikely to be those contemplated by the parties. An example of how difficult it is to show frustration is that many of the Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 283 leading cases relate to the abdication of King Edward VIII before his coronation and the impact that had on contracts entered into in anticipation of the coronation ceremony. Given force majeure clauses are creatures of contract their interpretation will be governed by the normal rules of contractual construction. Force majeure provisions will be construed strictly and in the event of any ambiguity the contra proferentem rule will apply. Contra proferentem literally means “against the party putting forward”. In this context, it means that the clause will be interpreted against the interests of the party that drafted and is seeking to rely on it. The parties may contract out of this rule. The rule of ejusdem generis, which literally means “of the same class”, may also be relevant. In other words, when general wording follows a specific list of events, the general wording will be interpreted in light of the specific list of events. In this context it means that when a broad “catch-all” phrase, (such as “anything beyond the reasonable control of the parties”) follows a list of more specific force majeure events the catch all phrase will be limited to events analogous to the listed events. Importantly, parties cannot invoke a force majeure clause if they are relying on their own acts or omissions. The underlying test in relation to most force majeure provisions is whether a particular event was within the contemplation of the parties when they made the contract. The event must also have been outside the control of the contracting party. There are generally three essential elements to force majeure:  It can occur with or without human intervention  It cannot have reasonably been foreseen by the parties  It was completely beyond the parties’ control and they could not have prevented its consequences. Given the relative uncertainty surrounding the meaning of force majeure we favour explicitly defining what the parties mean. This takes the matter out of the hands of the courts and gives control back to the parties. Therefore, it is appropriate to consider how force majeure risk should be allocated. (b) Drafting force majeure clauses The appropriate allocation of risk in project agreements is fundamental to negotiations between the Project Company and its Contractors. Risks generally fall into the following categories:  Risks within the control of the Project Company  Risks within the control of the Contractor  Risks outside the control of both parties. The negotiation of the allocation of many of the risks beyond the control of the parties, for example, latent site conditions and change of law, is usually very detailed so that it is clear which risks are borne by the Contractor. The same approach should be adopted in relation to the risks arising from events of force majeure. There are two aspects to the operation of force majeure clauses:  The definition of force majeure events  The operative clause that sets out the effect on the parties’ rights and obligations if a force majeure event occurs. The events which trigger the operative clause must be clearly defined. As noted above, it is in the interests of both parties to ensure that the term force majeure is clearly defined. The preferred approach for a Project Company is to define force majeure events as being any of the events in an exhaustive list set out in the contract. In this manner, both parties are aware of which events are force majeure events and which are not. Clearly, defining force majeure events makes the administration of the contract and, in particular, the mechanism within the contract for dealing with force majeure events simpler and more effective. Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 284 An example exhaustive definition is: “An Event of Force Majeure is an event or circumstance which is beyond the control and without the fault or negligence of the party affected and which by the exercise of reasonable diligence the party affected was unable to prevent provided that event or circumstance is limited to the following: a) riot, war, invasion, act of foreign enemies, hostilities (whether war be declared or not) acts of terrorism, civil war, rebellion, revolution, insurrection of military or usurped power, requisition or compulsory acquisition by any governmental or competent authority b) ionising radiation or contamination, radio activity from any nuclear fuel or from any nuclear waste from the combustion of nuclear fuel, radioactive toxic explosive or other hazardous properties of any explosive assembly or nuclear component c) pressure waves caused by aircraft or other aerial devices travelling at sonic or supersonic speeds; d) earthquakes, flood, fire or other physical natural disaster, but excluding weather conditions regardless of severity e) strikes at national level or industrial disputes at a national level, or strike or industrial disputes by labour not employed by the affected party, its subContractors or its suppliers and which affect an essential portion of the Works but excluding any industrial dispute which is specific to the performance of the Works or this Contract.” An operative clause will act as a shield for the party affected by the event of force majeure so that a party can rely on that clause as a defence to a claim that it has failed to fulfil its obligations under the contract. An operative clause should also specifically deal with the rights and obligations of the parties if a force majeure event occurs and affects the project. This means the parties must consider each of the events it intends to include in the definition of force majeure events and then deal with what the parties will do if one of those events occurs. An example of an operative clause is: “[ ].1 Neither party is responsible for any failure to perform its obligations under this Contract, if it is prevented or delayed in performing those obligations by an Event of Force Majeure [ ].2 Where there is an Event of Force Majeure, the party prevented from or delayed in performing its obligations under this Contract must immediately notify the other party giving full particulars of the Event of Force Majeure and the reasons for the Event of Force Majeure preventing that party from, or delaying that party in performing its obligations under this Contract and that party must use its reasonable efforts to mitigate the effect of the Event of Force Majeure upon its or their performance of the Contract and to fulfil its or their obligations under the Contract [ ].3 Upon completion of the Event of Force Majeure the party affected must as soon as reasonably practicable recommence the performance of its obligations under this Contract. Where the party affected is the Contractor, the Contractor must provide a revised Program rescheduling the Works to minimise the effects of the prevention or delay caused by the Event of Force Majeure [ ].4 An Event of Force Majeure does not relieve a party from liability for an obligation which arose before the occurrence of that event, nor does that event affect the obligation to pay money in a timely manner which matured prior to the occurrence of that event. [ ].5 The Contractor has no entitlement and the Project Company has no liability for: (a) any costs, losses, expenses, damages or the payment of any part of the Contract Price during an Event of Force Majeure (b) any delay costs in any way incurred by the Contractor due to an Event of Force Majeure.” Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 285 In addition to the above clause, it is important to appropriately deal with other issues that will arise if a force majeure event occurs. For example, as noted above, it is common practice for a Contractor to be entitled to an extension of time if a force majeure event impacts on its ability to perform the works. Contractors also often request costs if a force majeure event occurs. In our view, this should be resisted. Force majeure is a neutral risk in that it cannot be controlled by either party. Therefore, the parties should bear their own costs. Another key clause that relates to force majeure type events is the Contractor’s responsibility for care of the works and the obligation to reinstate any damage to the works prior to completion. A common example clause is: “[ ].1 The Contractor is responsible for the care of the Site and the Works from when the Project Company makes the Site available to the Contractor until 5.00 pm on the Date of Commercial Operation [ ].2 The Contractor must promptly make good loss from, or damage to, any part of the Site and the Works while it is responsible for their care [ ].3 If the loss or damage is caused by an Event of Force Majeure, the Project Company may direct the Contractor to reinstate the Works or change the Works. The cost of the reinstatement work or any change to the Works arising from a direction by the Project Company under this clause will be dealt with as a Variation except to the extent that the loss or damage has been caused or exacerbated by the failure of the Contractor to fulfil its obligations under this Contract [ ].4 Except as contemplated in clause [ ].3, the cost of all reinstatement Works will be borne by the Contractor.” This clause is useful because it enables the Project Company to, at its option, have the damaged section of the project rebuilt as a variation to the existing EPC Contract. This will usually be cheaper than recontracting for construction of the damaged sections of the works. Operation and maintenance (a) Operating and maintenance manuals The Contractor is usually required to prepare a detailed operating and maintenance manual (O&M manual). The EPC Contract should require the Contractor to prepare a draft of the O&M manual within a reasonable time to enable the Project Company, the Operator and possibly the Lenders to provide comments which can be incorporated into a final draft at least six months before the start of commissioning. The draft should include all information that may be required for start-up, all modes of operation during normal and emergency conditions and maintenance of all systems of the facility. (b) Operating and maintenance personnel It is standard for the Contractor to be obliged to train the operations and maintenance staff supplied by the Project Company. The cost of this training will be built into the contract price. It is important to ensure the training is sufficient to enable such staff to be able to efficiently, prudently, safely and professionally operate the facility upon commercial operation. Therefore, the framework for the training should be described in the Appendix dealing with the scope of work (in as much detail as possible). This should include the standards of training and the timing for training. The Project Company’s personnel trained by the Contractor will also usually assist in the commissioning and testing of the facility. They will do this under the direction and supervision of the Contractor. Therefore, absent specific drafting to the contrary, if problems arise during commissioning and/or testing the Contractor can argue they are entitled to an extension of time etc. We recommend inserting the following clause: “[ ].1 The Project Company must provide a sufficient number of competent and qualified operating and maintenance personnel to assist the Contractor to properly carry out Commissioning and the Commercial Operation Performance Tests Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 286 [ ].2 Prior to the Date of Commercial Operation, any act or omission of any personnel provided by the Project Company pursuant to GC [ ].1 is, provided those personnel are acting in accordance with the Contractor’s instructions, directions, procedures or manuals, deemed to be an act or omission of the Contractor and the Contractor is not relieved of its obligations under this Contract or have any claim against the Project Company by reason of any act or omission.” Spare parts The Contractor is usually required to provide, as part of its scope of works, a full complement of spare parts (usually specified in the appendices (the scope of work or the specification) to be available as at the commencement of commercial operation. Further, the Contractor should be required to replace any spare parts used in rectifying defects during the defects liability period, at its sole cost. There should also be a time limit imposed on when these spare parts must be back in the store. It is normally unreasonable to require the spare parts to have been replaced by the expiry of the defects liability period because that may, for some long lead time items, lead to an extension of the defects liability period. The Project Company also may wish to have the option to purchase spares parts from the Contractor on favourable terms and conditions (including price) during the remainder of the concession period. In that case it would be prudent to include a term which deals with the situation where the Contractor is unable to continue to manufacture or procure the necessary spare parts. This provision should cover the following points:  Written notification from the Contractor to the Project Company of the relevant facts, with sufficient time to enable the Project Company to order a final batch of spare parts from the Contractor  The Contractor should deliver to, or procure for the Project Company (at no charge to the Project Company), all drawings, patterns and other technical information relating to the spare parts  The Contractor must sell to the Project Company (at the Project Company’s request) at cost price (less a reasonable allowance for depreciation) all tools, equipment and moulds used in manufacturing the spare parts, to extent they are available to the Contractor provided it has used its reasonable endeavours to procure them. The Contractor should warrant that the spare parts are fit for their intended purpose, and that they are of merchantable quality. As a minimum, this warranty should expire on the later of:  The manufacturer’s warranty period on the applicable spare part  The expiry of the defects liability period. The Project Company should be aware that the Contractor may be purchasing the spare parts from the Original Equipment Manufacturer (OEM). The OEM will have typically imposed non-negotiable warranties on the spare parts that the Contractor will try to pass-through to the Project Company. This should be resisted on the part of the Project Company. However, the Project Company should be prepared to pay higher prices for those spare parts to reflect the greater risk the Contractor will be accepting in place of the pass-through of the OEM warranties. Interface issues In some circumstances, a split contract structure may be used to achieve a lower overall contract price than would be achieved under an EPC Contract. For example, a structure with a BOP contract and an equipment supply contract may be used. However, if a split structure is used, it is critical that a single point of responsibility is provided. If not, the Project Company will be left with interface risk which will impact on bankability. Matters that are critical to providing a single point of responsibility are:  Providing that no claim is available by the Contractor against the Project Company arising out of an act or omission of any other Contractor Construction, operation, regulatory and bankability issues for utility scale renewable energy projects PwC 287  Preventing split Contractors from having the ability to make a claim on the Project Company due to the default of one of the other contracting entities (eg equipment supply Contractor claiming against the Project Company for a default caused by the balance of plant Contractor). If a split contract structure is used, we recommend inserting the following clauses: “No relief [ ] Neither Contractor 1 nor Contractor 2 will be entitled to payment of any sum from the Project Company or to relief from any obligation to make payment of any sum to the Project Company or be entitled to relief from or reduction of any other liability, obligation or duty arising out of or in connection with the contracts including (without limitation): [ ].1 any extension of time [ ].2 any relief from liability for liquidated damages; [ ].3 any relief from liability for any other damages; [ ].4 any relief for deductions from payments [ ].5 any relief from liability to rectify defects [ ].6 any increase in the contract sum under the contracts [ ].7 payment of any costs incurred which arises out of or in connection with any act or omission of the other, whether pursuant to or in connection with any of the contracts or otherwise. Horizontal defences [ ] Contractor 1 and Contractor 2 each waive any and all rights, under contract, tort or otherwise at law, to assert any and all defences which either of Contractor 1 or Contractor 2 may have to a claim by the Project Company for the non-performance, inadequate performance or delay in performance under their respective Contract due to any non-performance or inadequate performance or delay in performance by the other party under its Contract.” Dispute resolution Dispute resolution provisions for EPC Contracts could fill another entire paper. There are numerous approaches that can be adopted depending on the nature and location of the project and the particular preferences of the parties involved. However, there are some general principles which should be adopted. They include:  Ensuring that the dispute resolution process is aligned with that under the PPA  Having a staged dispute resolution process that provides for internal discussions and meetings aimed at resolving the dispute prior to commencing action (either litigation or arbitration)  Obliging the Contractor to continue to execute the works pending resolution of the dispute  Not permitting commencement of litigation or arbitration, as the case may be, until after commercial operation of the facility. This provision must make exception for the parties to seek urgent interlocutory relief  Providing for consolidation of any dispute with other disputes which arise out of or in relation to the construction of the facility. The power to consolidate should be at the Project Company’s discretion. PwC 288 Appendix 1 Example clauses Part I – Extension of time regime [ ].1 The Contractor must immediately give notice to the Project Company of all incidents and/or events of whatsoever nature affecting or likely to affect the progress of the Works. [ ].2 Within 15 days after an event has first arisen the Contractor must give a further notice to the Project Company which must include: (a) the material circumstances of the event including the cause or causes (b) the nature and extent of any delay (c) the corrective action already undertaken or to be undertaken (d) the effect on the critical path noted on the Program (e) the period, if any, by which in its opinion the Date for Commercial Operation should be extended (f) a statement that it is a notice pursuant to this GC [ ].2. [ ].3 Where an event has a continuing effect or where the Contractor is unable to determine whether the effect of an event will actually cause delay to the progress of the Works so that it is not practicable for the Contractor to give notice in accordance with GC [ ].2, a statement to that effect with reasons together with interim written particulars (including details of the likely consequences of the event on progress of the Works and an estimate of the likelihood or likely extent of the delay) must be submitted in place of the notice required under GC [ ].2. The Contractor must then submit to the Project Company, at intervals of 30 days, further interim written particulars until the actual delay caused (if any) is ascertainable, whereupon the Contractor must as soon as practicable but in any event within 30 days give a final notice to the Project Company including the particulars set out in GC [ ].2. [ ].4 The Project Company must, within 30 days of receipt of the notice in GC [ ].2 or the final notice in GC [ ].3 (as the case may be), issue a notice notifying the Contractor’s Representative of its determination as to the period, if any, by which the Date for Commercial Operation is to be extended. [ ].5 Subject to the provisions of this GC [ ], the Contractor is entitled to an extension of time to the Date for Commercial Operation as the Project Company assesses, where a delay to the progress of the Works is caused by any of the following events, whether occurring before, on or after the Date for Commercial Operation: (a) any act, omission, breach or default by the Project Company, the Project Company’s Representative and their agents, employees and Contractors (b) a Variation, except where that Variation is caused by an act, omission or default of the Contractor or its SubContractors, agents or employees (c) a suspension of the Works pursuant to GC [ ], except where that suspension is caused by an act, omission or default of the Contractor or its SubContractors, agents or employees (d) an Event of Force Majeure (e) a Change of Law. Example clauses PwC 289 [ ].6 Despite any other provisions of this GC [ ], and notwithstanding that the Contractor is not entitled to or has not claimed an extension of time to the Date for Commercial Operation, the Owner may, in its absolute sole and unfettered discretion, at any time grant an extension of the Date for Commercial Operation. The Owner has no obligation to grant, or to consider whether it should grant, an extension of time and is not required to exercise this discretion for the benefit of the Contractor. [ ].7 The Contractor must constantly use its best endeavours to avoid delay in the progress of the works. [ ].8 If the Contractor fails to submit the notices required under GCs [ ].1, [ ].2 and [ ].3 within the times required then: (a) the Contractor has no entitlement to an extension of time (b) the Contractor must comply with the requirements to perform the Works by the Date for Commercial Operation (c) any principle of law or equity (including those which might otherwise entitle the Contractor to relief and the “Prevention Principle”) which might otherwise render the Date for Commercial Operation immeasurable and liquidated damages unenforceable, will not apply. [ ].9 It is a further condition precedent of the Contractor’s entitlement to an extension of time that the critical path noted on the Program is affected in a manner which might reasonably be expected to result in a delay to the Works reaching Commercial Operation by the Date for Commercial Operation. [ ].10 If there are two or more concurrent causes of delay and at least one of those delays would not entitle the Contractor to an extension of time under this GC [ ] then, to the extent of that concurrency, the Contractor is not entitled to an extension of time. [ ].11 The Project Company may direct the Contractor’s Representative to accelerate the Works for any reason including as an alternative to granting an extension of time to the Date for Commercial Operation. [ ].12 The Contractor will be entitled to all extra costs necessarily incurred, by the Contractor in complying with an acceleration direction under GC [ ].11, except where the direction was issued as a consequence of the failure of the Contractor to fulfil its obligations under this Contract. The Project Company must assess and decide as soon as reasonably practical, the extra costs necessarily incurred by the Contractor. Part II – Grid access regime [ ].1 The Contractor must co-ordinate the connection of the Facility to the Transmission Line and provide, in a timely manner, suitable termination facilities in accordance with Appendix 1. The Contractor must liaise with the Network Service Provider, Government Authorities and other parties to avoid delays in connecting the Facility to the Transmission Line. [ ].2 On the Date for First Synchronisation the Project Company must ensure that there is in place a Transmission Network which is capable of receiving the generated output the Facility is physically capable of producing at any given time. [ ].3 The Project Company’s obligation to ensure that the Transmission Network is in place is subject to the Contractor being able (physically and legally) to connect the Facility to the Transmission Line and import and/or export power to the Transmission Network. [ ].4 If the Contractor notifies the Project Company that First Synchronisation is likely to take place before the Date for First Synchronisation, the Project Company must endeavour, but is under no obligation to ensure that the Transmission Network is in place, to enable First Synchronisation to take place in accordance with the Contractor’s revised estimate of First Synchronisation. Example clauses PwC 290 [ ].5 At the time of and following First Synchronisation the Project Company will ensure that the Contractor is permitted to export to the Transmission Network power which the Facility is physically capable of exporting, provided that: (a) it is necessary for the Contractor to export that amount of power if the Contractor is to obtain Commercial Operation (b) the Contractor has complied in all respects with its obligations under GC [ ].7 (c) in the reasonable opinion of the Project Company and/or the Network Service Provider the export of power by the Facility will not pose a threat to the safety of persons and/or property (including the Transmission Network). [ ].6 For the avoidance of doubt, the Project Company will not be in breach of any obligation under this Contract by reason only of the Contractor being denied permission to export power to the Transmission Network in accordance with the Grid Code. [ ].7 The Contractor must carry out the testing of the Works, in particular in relation to the connection of the Facility to the Transmission Network so as to ensure that the Project Company and the Contractor as a Participant (as defined in the Electricity Code) comply with their obligations under the Electricity Code in respect of the Testing of the Works, [ ].8 The Contractor must carry out the Testing of the Works, in particular in relation to the connection of the Facility to the Transmission Network, so as to ensure that: (a) any interference to the Transmission Network is minimised (b) damage to the Transmission Network is avoided. [ ].9 The Contractor must promptly report to the Project Company’s Representative any interference with and damage to the Transmission Network which connects with the Facility. [ ].10 Without derogating from the Contractor’s obligations under this Contract, in carrying out any test which requires the Contractor to supply electricity to the Transmission Network, the Contractor must: (a) issue a notice to the Project Company’s Representative at least 24 hours prior to the time at which it wishes to so supply, detailing the testing or commissioning and including the Contractor’s best estimate of the total period and quantity (in MWh per half-hour) of that supply (b) promptly notify the Project Company’s Representative if there is any change in the information contained in such notice (c) do all things necessary to assist the Project Company (including but not limited to cooperating with the Network Service Provider and complying with its obligations under GC 20.15), so that the Project Company can comply with its obligations under the National Electricity Code. Example clauses PwC 291 Part III – Performance testing and guarantee regime 1 Testing Tests and inspections 1.1 The Contractor must, at its own expense, carry out at the place of manufacture and/or on the Site all tests and/or inspections of the Equipment and any part of the Works as specified in this Contract or as required by any applicable Laws, and as necessary to ensure the Facility operates safely and reliably under the conditions specified in the Schedule of Scope of Work and the Schedule of Tests. [Note: Schedule of Tests should specify all the categories of tests other than the Tests (example: test at manufacturers plant, test on site, functional test etc.)] 1.2 The Contractor must also comply with any other requirements of the Owner in relation to testing and inspection. 1.3 The Owner and the Lenders’ Representative are entitled to attend any test and/or inspection by its appointed duly authorised and designated inspector. 1.4 Whenever the Contractor is ready to carry out any test and/or inspection, the Contractor must give a reasonable advance notice to the Owner of the test and/or inspection and of the place and time. The Contractor must obtain from any relevant third party or manufacturer any necessary permission or consent to enable the Owner’s inspector and the Lenders’ Representative to attend the test and/or inspection. 1.5 The Contractor must provide the Owner’s Representative with a certified report of the results of any test and/or inspection within 5 days of the completion of that test or inspection. 1.6 If the Owner or the Lenders’ Representative fails to attend the test and/or inspection, or if it is agreed between the parties that the Owner or the Lenders’ Representative will not attend, then the Contractor may proceed with the test and/or inspection in the absence of the Owner’s inspector and provide the Owner and the Lenders’ Representative with a certified report of the results. 1.7 The Owner may require the Contractor to carry out any test and/or inspection not described in this Contract. The Contractor’s extra costs necessarily incurred, which do not include head office or corporate overheads, profit or loss of profit, in the carrying out of the test and/or inspection will be added to the Contract Price only if the test shows that the relevant Works conform with the requirements of the Contract, but otherwise all costs will be borne by the Contractor. 1.8 If any Equipment or any part of the Works fails to pass any test and/or inspection, the Contractor must either rectify to the Owner’s satisfaction or replace such Equipment or part of the Works and must repeat the test and/or inspection upon giving a notice under GC 1.4. 1.9 The Contractor must afford the Owner and the Lenders’ Representative access at any time to any place where the Equipment is being manufactured or the Works are being performed in order to inspect the progress and the manner of manufacture or construction, provided that the Owner gives the Contractor reasonable prior notice. 1.10 The Contractor agrees that neither the execution of a test and/or inspection of Equipment or any part of the Works, nor the attendance by either or both the Owner and the Lenders’ Representative nor the issue of any test report pursuant to GC 1.5 releases the Contractor from any other responsibilities under this Contract. 1.11 No part of the Works are to be covered up on the Site without carrying out any test and/or inspection required under this Contract and the Contractor must give reasonable notice to the Owner whenever any part of the Works are ready or about to be ready for test and/or inspection. Example clauses PwC 292 1.12 The Contractor must uncover any part of the Works or make openings in or through the same as the Owner may from time to time require at the Site and must reinstate and make good that part. 1.13 If any part of the Works have been covered up at the Site after compliance with the requirement of GC 1.12 and are found to be performed in accordance with the Contract, the Contractor’s extra costs, which do not include head office or corporate overheads, profit or loss of profit, necessarily incurred in uncovering, making openings in or through, reinstating and making good the same will be added to the Contract Price. Performance tests procedures and guidelines 1.14 The relevant Performance Tests must be conducted by the Contractor after Commissioning to ascertain whether the Facility can achieve Completion and after Completion to ascertain whether the Facility can meet the Performance Guarantees. 1.15 All Performance Tests must be conducted in a professional, timely, safe and environmentally responsible manner and in accordance with the Schedule of Scope of Work and the Schedule of Tests, all other terms and conditions of this Contract, applicable standards, Laws, Government Approvals and must be accomplished at no additional cost or expense to the Owner. 1.16 The Facility must not be operated during any Performance Test in excess of: (a) the limits allowed by any manufacturer to maintain its warranty (b) the limits imposed by the Law and Government Approvals applicable standards (c) the limits stated in the Schedule of Tests. 1.17 The Contractor agrees that the Owner and the Lenders’ Representative will monitor the conduct of the Performance Testing to ensure compliance with the terms and conditions of this Contract. 1.18 The Contractor agrees that an inspection pursuant to GC 1.17 by the Owner and/or the Lenders’ Representative does not release the Contractor from any other responsibilities under this Contract, including meeting the Performance Guarantees. 1.19 If a Performance Test is interrupted or terminated, for any reason, that Performance Test must be restarted from the beginning, unless otherwise approved by the Owner or the Lenders’ Representative. 1.20 The Owner or the Contractor is entitled to order the cessation of any Performance Test if: (a) damage to the Works, the Facility or other property or personal injury (b) breach of the conditions specified in the relevant environmental Laws or Government Approvals, is likely to result from continuation. 1.21 If the Contractor fails to pass a Performance Test (or any repetition in the event of prior failure) or if a Performance Test is stopped before its completion, that Performance Test must, subject to 24 hours prior notice having been given by the Contractor to the Owner and the Lenders’ Representative, be repeated as soon as practicable. All appropriate adjustments and modifications are to be made by the Contractor with all reasonable speed and at its own expense before the repetition of any Performance Test. 1.22 The results of the Performance Tests must be presented in a written report, produced by the Contractor and delivered to the Owner and the Lenders’ Representative within 5 days of the completion of the Tests. Those results will be evaluated by the Owner and the Lenders’ Representative. In evaluation of the results, no additional allowance will be made for measurement tolerances over and above those specified in the applicable ISO test standard. Example clauses PwC 293 Sale of electricity during the performance tests 1.23 The Contractor acknowledges and agrees that: (a) the Owner is entitled to all energy, revenues and other benefits, including all Renewable Energy Certificates under the REC Act, carbon credits and all other “green” renewable energy credits, that may be generated or derived from the Facility during the Performance Tests or otherwise (b) nothing in this Contract imposes any restrictions on the Owner from selling any electricity generated during the Performance Tests. 2 Precommissioning, commissioning and tests on completion Precommissioning 2.1 The Contractor must perform the Precommissioning of the Facility in accordance with the Owner’s requirements and procedures in relation to Precommissioning as set out in the Schedule of Scope of Work. 2.2 As soon as all works in respect of Precommissioning are completed and, in the opinion of the Contractor, the Facility is ready for Commissioning, the Contractor must give notice to that effect to the Owner. As soon as reasonably practicable after receipt of that notice, the Owner must issue a notice to the Contractor specifying the date for commencement of Commissioning. Commissioning 2.3 On the date specific in the notice issued by the Owner under clause 2.3, the Contractor must commence Commissioning of the Facility in accordance with the requirements and procedures in relation to Commissioning as set out in the Schedule of Scope of Work. Performance tests 2.5 (a) After the completion of Commissioning the Contractor must give the Owner at least 10 Days prior written notice that the Equipment, Works and Facility (or any component part of the Works and Facility) are ready for the Commercial Operation Performance Tests. (b) The Owner must, as soon as reasonably practicable, after receipt of a notice under GC 2.5(a), issue a notice to the Contractor specifying the date for commencement of the Commercial Operation Performance Tests if such a date is not already identified in the Program and the Schedule of Tests. 3 Commercial operation, post-commercial operation and final completion Completion 3.1 (a) The Contractor must notify the Owner at least [70] Days before the whole of the Works will, in the opinion of the Contractor reach the stage of Commercial Operation and be suitable for the issue of the Facility Completion Form by the Independent Engineer. (b) As soon as the whole of the Works have, in the opinion of the Contractor, satisfied each of the preconditions for achieving Commercial Operation, including that the Facility Completion Form has been issued to the Owner by the Independent Engineer, the Contractor must give a notice to that effect to the Owner. Example clauses PwC 294 (c) The Owner’s Representative must, promptly, and no later than 10 days after receipt of the Contractor’s notice under GC 3.1(b), either issue a Certificate of Commercial Operation stating that the Facility has achieved Commercial Operation or notify the Contractor that the Facility has not achieved Commercial Operation and indicate any defects and/or deficiencies. (d) Despite any other provision of this Contract, no payment and no partial or entire use or occupancy of the Site, the Works or the Facility by the Owner in any way constitutes an acknowledgment by the Owner that Commercial Operation has occurred, nor does it operate to release the Contractor from or otherwise affect any of the Contractor’s warranties, obligations or liabilities under or in connection with this Contract. (e) If the Owner’s Representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct those defects and/or deficiencies and the procedures described in this GCs 3.1 must be repeated until the Owner issues a Certificate of Commercial Operation. (f) Upon the issue of the Certificate of Commercial Operation, the Contractor must handover care, custody and control of the Facility to the Owner. Post-commercial operation performance tests 3.2 (a) The Contractor must give the Owner prior written notice of when it intends to carry any of the Post Commercial Operation Performance Tests at the times and in accordance with the requirements set out in the Schedule of Tests. (b) As soon as reasonably practicable after receipt of a notice under GC 3.2(a), the Owner must issue a notice to the Contractor specifying the date for commencement of the Post Commercial Operation Performance Tests at the times and in accordance with the Schedule of Tests. Final completion 3.3 (a) As soon as the Facility, in the opinion of the Contractor, reaches the stage of Final Completion the Contractor must give a notice to the Owner. (b) The Owner’s Representative must, promptly, and no later than 10 days after receipt of the Contractor’s notice under GC 3.6(a), either issue a Certificate of Final Completion stating that the Facility has reached Final Completion or notify the Contractor of any defects and/or deficiencies. (c) If the Owner’s Representative notifies the Contractor of any defects and/or deficiencies, the Contractor must then correct those defects and/or deficiencies and the procedures described in GCs 3.6(a) and (b) must be repeated until the Owner issues a Certificate of Final Completion. (d) Despite any other provision of this Contract, no partial or entire use or occupancy of the Site, the Works or the Facility by the Owner, whether during the Tests after Completion or otherwise, in any way constitutes an acknowledgment by the Owner that Final Completion has occurred, nor does it operate to release the Contractor from any of its warranties, obligations or liabilities under this Contract including the satisfactory performance of its obligations during the Defects Liability Period, the carrying out of the Tests after Completion and meeting the Performance Guarantees. PwC 295 Appendix 2 Diagrammatic representation of performance testing, performance guarantee and compensation arrangements for a sample solar PV project Diagrammatic representation of performance testing, performance guarantee and compensation arrangements for a sample solar PV project PwC 296 Diagrammatic representation of performance testing, performance guarantee and compensation arrangements for a sample solar PV project Capacity gap → payment of PLDs {or a reduction in Contract Price} for performance Shortfall Time for performance Pre-COD Testing 1 Payment of Delay LDs Payment of PLDs (however this could be every 12 months during DLP) Time for Post - COD Performance Testing a = year COD = Commercial Operation Date MPR = Minimum Performance Requirements PPA = Power PurchaseAgreement TO = Taking Over (= issuance of Taking Over Certificate {TOC}) 1 = retesting during testing period possible Concentrated Net Power Output Achieved Net Power Output MPR Client’s View: Project Execution Performance Testing Period DELAY (20a – X) PPA operation TO Performance Test Retesting 1. Synch To Net Power Output Date of scheduled commercial operation Date of achieved commercial operation {DLP commences} Date of final completion (expire of original DLP) Tested Net Power Output PwC 297 12 The elephant in the room dispute resolution processes for RE IPP programme introduction Now that the successful bids from Phase 1 of South Africa’s Renewable Energy Independent Power Producer (RE IPP) Programme have reached financial close, project companies overseeing the development of these projects need to turn their minds to the administration of the contracts underpinning these projects. One matter with the potential to create issues is where there are differences between the dispute resolution procedure set out in the Power Purchase Agreement (PPA) that project companies are required to enter into with Eskom Holdings SOC Limited (Eskom) and the dispute resolution procedures negotiated in the construction and operation contracts (generally Engineering, Procurement and Construction (EPC) and Operation and Management (O&M) Contracts) between project companies and EPC and O&M Contractors. The dispute resolution procedure set out in the PPA provides for litigation of disputes in the High Court of South Africa. In contrast, the dispute resolution procedure negotiated in many of the EPC and O&M Contracts under the RE IPP Programme provide for arbitration of disputes, commonly under the International Chamber of Commerce (ICC) Rules of Arbitration or the Arbitration Foundation of South Africa Rules. This paper discusses the dispute resolution processes under the PPA and EPC and O&M Contracts, along with issues that may arise in disputes under the aforementioned contracts under the RE IPP Programme that, due to the nature of the dispute or the relationship of the parties, have not been resolved at any intermediate stage in a dispute resolution process and proceed to the final stage of litigation or arbitration, as relevant. Although it is acknowledged that some types of disputes that may arise in respect of the RE IPP Programme projects may be more appropriately resolved by alternative dispute resolution procedures (such as disputes involving valuations, defects and other technical issues relating to the facility which may more appropriately be resolved by an independent expert), these matters are not the subject of this paper. Why provide for arbitration under the EPC and O&M contracts? The question may be asked: why don’t all EPC and O&M Contracts provide dispute resolution procedures that mimic the procedure set out in the PPA? Issues identified in PPA drafting Firstly, a number of issues have been issues identified with the dispute resolution processes provided under the PPA. The standard “internal referral” process (outlined below) does not provide for service of a notice of dispute to define and crystallise the nature of the issues for discussions between the parties. The provision for the dispute to be referred to the liaison officers or “other designated executives from each party” is undesirable as it leaves the nomination of personnel open-ended and may allow the parties to manipulate a dispute by delaying the appointment of relevant officers to deal with the dispute at the initial stage. The elephant in the room dispute resolution processes for RE IPP programme introduction PwC 298 The PPA also provides the additional “fast track” process of dispute resolution using an independent expert. There have also been a number of issues identified with this process including that:  tt is not always clear in what circumstances the fast track dispute procedure is to be applied under the PPA  there is no provision for the method of appointing the expert  the expert’s discretion is wide-ranging with only limited checks and balances  there is no provision to appeal the decision of the expert. As the PPA is non-negotiable, these identified issues cannot be addressed or mitigated under the PPA by the parties. As a result of the non-negotiable nature of these issues, parties have been reluctant to adopt the dispute resolution processes set out in the PPA in the EPC and O&M Contracts. Preference for arbitration Given that many of the parties involved in the RE IPP Programme projects are international developers, contractors and suppliers, there has been a strong preference for the parties to use arbitration (rather than litigation) as the preferred dispute resolution mechanism. This preference is based on a range of reasons such as:  the enforceability of the arbitration award on a near-worldwide basis, as opposed to the more limited recognition of foreign judgments  finality of the arbitration award, as opposed to the avenues of appeal that exist in litigation  specific expertise of arbitrators in particular subject matter areas  privacy due to the confidentiality of arbitral proceedings and awards  time savings  a broad acknowledgement and understanding of commonly used arbitration rules such as the ICC rules  in some cases, the perception of increased impartiality due to resolution of the dispute occurring outside of a country-specific judiciary. Recognition of a judgment can be uncertain where either or both jurisdictions are not party to formal reciprocity agreements such as the Hague Convention on the Recognition and Enforcement of Foreign Judgments in Civil and Commercial Matters, or are not nominated as reciprocal jurisdictions in their domestic legislation. In some cases it may be that the issue of enforcement can only be resolved by further litigation. The elephant in the room dispute resolution processes for RE IPP programme introduction PwC 299 Dispute resolution procedure – PPA If a party to the PPA defaults in the performance of its obligations and a dispute arises “in relation to or in connection with any aspect of” the PPA, as noted above the two dispute resolution procedures that may apply under the PPA are “internal referral” and “fast track”. Internal referral If a dispute arises, either party can refer the dispute to a meeting of the liaison officer, or other designated executives from each party who are  actively involved in the ownership or lease of the project site and the ownership, construction, operation and maintenance of the facility  sufficiently authorised to resolve the dispute. Should the parties be unable to resolve the dispute within 15 days of this referral, either party may refer the dispute for a decision by the accounting officer/authority of Eskom and the CEO/equivalent officer of the Project Company. The parties and their employees and representatives must use reasonable endeavours to resolve the dispute and must not be delayed by negotiations or any other informal procedure that the relevant representatives may adopt. If the dispute is not resolved within 15 days of referral, the dispute may be referred to litigation in the South African High Court by either party. The following flowchart provides a diagram of the dispute resolution procedure under the PPA: Fast track procedure The “fast track” procedure required to be followed in specified circumstances under the PPA results in referral of a dispute to an independent expert. This procedure is notable in terms of the risks posed to a Project Company if it is deemed to have failed to cooperate in the fast track procedure. Under this fast track procedure, the expert is expressly afforded the same powers as a judge of the High Court of South Africa, unless restrained by law from exercising such power or ordering such relief. Should the Project Company fail to cooperate with the independent expert, for example, on the basis that the Project Company considers that the subject of the dispute was caused by the Contractor under the EPC or O&M Contract, as relevant, and the independent expert believes that such default or omission prejudices the adjudication procedure, the independent expert can order that the Project Company forfeits the right to continue to participate in the adjudication, the outcome of which is final and binding. Dispute arises Referral to liaison officers/other designated executives from each party for resolution [cl. 26.2.1.1] If not resolved within 15 days, escalation to accounting officer/authority of Eskom and the CEO /equivalent officer of the Project Company [cl. 26.2.1.2] If not resolved in 15 days, referral to the High Court of South Africa by either party [cl. 26.4.2] The elephant in the room dispute resolution processes for RE IPP programme introduction PwC 300 General dispute resolution procedure – EPC and O&M contracts Escalating dispute procedure EPC and O&M Contracts generally provide a staged dispute resolution procedure that commences with internal discussions for a specified amount of time aimed at resolving the dispute prior to commencing formal proceedings – An example of such a procedure is set out below. The dispute must first be referred to the Project Company’s representative and the Contractor’s representative, who then have a specified period in which to resolve the dispute. After the specified period has elapsed, either party may refer the dispute to an executive panel comprised of the CEO or equivalent of the Project Company and the Contractor. After considering the issues, the executive panel may then issue a written decision that is binding upon the parties. If the executive panel does not resolve the dispute within a specified period, or agree upon alternative procedures to determine the dispute, then either party may commence arbitration. The completion of this staged escalating procedure is a condition precedent to arbitration. Only once one of the parties has attempted to follow the procedure (and the procedure has failed to resolve the dispute) can the parties agree to resolve the dispute by way of arbitration. The elephant in the room? The misalignment between the PPA and the EPC and O&M Contracts or procedures may present an issue if a dispute arises:  under an EPC or O&M Contract where the relevant Contractor alleges default by the Project Company  under the PPA where Eskom alleges default by the Project Company. and the Project Company alleges that its default in either scenario is due to an act or omission of a third party that is not a party to the specific contract under which the Project Company is alleged to have defaulted, but that third party is actively involved in the project and has entered into a separate agreement with the Project Company (eg Eskom in example 1 and the EPC or O&M Contractor in example 2). In such a situation the Project Company will be faced with two issues: Recourse from the defaulting party The third party is not obliged to participate in a dispute resolution procedure under a contract to which it is not a party. If a third party is not willing to negotiate its liability or participate in the dispute resolution process by consent (notwithstanding that it may have contributed to a default of the contract by a party to that contract), the party seeking to join that third party will need to begin a sometimes protracted process of requiring joinder. Continuing obligation to follow dispute resolution procedures As the party with concurrent obligations under both the PPA and the EPC and O&M Contracts, the Project Company will be contractually obliged to follow the dispute resolution procedure under both contracts through the escalating stages that are a condition precedent to initiating formal proceedings, be that litigation or arbitration. Issues arising when a dispute under the EPC or O&M contract is due to a default of ESKOM. Hypothetically, if Eskom, through its own act or omission, has caused the Project Company to default on one of its contractual obligations under the EPC or O&M Contracts, as Eskom is not a party to these contracts it cannot be compelled to participate in the dispute resolution procedure due to the lack of privity of contract. Whilst the ICC rules, for example, allow for joinder of parties under article 7, this is only possible where the parties consent to be joined or are also subject to ICC arbitration agreements. No rule allows for the joinder of a party, however relevant to the dispute, that is not a party to an ICC arbitration agreement. The elephant in the room dispute resolution processes for RE IPP programme introduction PwC 301 Action under the PPA If Eskom’s act or omission that caused the Project Company to default under the EPC or O&M Contract can also be characterised as being the cause of “any dispute arising in relation to or in connection with any aspect” of the PPA, the Project Company could initiate a dispute under the PPA against Eskom. The dispute would then continue through the procedure set out by the PPA until it was resolved between Eskom and the Project Company. Action under the EPC or O&M Contracts If a Contractor sought to enforce its contractual rights against the Project Company and to initiate the dispute resolution procedure under the EPC or O&M Contract by serving notice of dispute upon the Project Company, given that it would not be able to join Eskom to the arbitration without consent, the Project Company should seek a stay of procedure to prevent the dispute from proceeding to arbitration until it is able to resolve the dispute with Eskom. If it is clear that the Contractor will not agree to a stay or otherwise cooperate, the Project Company should apply pursuant to section 3(2) of the Arbitration Act No. 42 of 1965 for an order that the dispute should not be referred to arbitration. To be successful in such an application, the Project Company must show “good cause” as to why such an order should be made – in such a case this could be argued to be due to the futility of the arbitration process without the involvement of Eskom. An application under this section would not place the Project Company in default of the EPC or O&M Contracts, provided that the relevant contract contains the standard provision that, notwithstanding any dispute resolution procedure set out in the contract, allows a party to apply to a court of competent jurisdiction to seek urgent or interim relief. If, through its own act or omission, the Contractor caused the Project Company to default on its obligations to Eskom under the PPA, the Contractor (which is not a party to the PPA) cannot be compelled to participate in the resolution of the dispute under the process set out in the PPA due to the lack of privity of contract. Action under the EPC or O&M contracts If the act or omission lending to the default under the PPA can also be characterised as a default causing a dispute to arise under the EPC or O&M Contract, the Project Company could initiate the dispute resolution procedure under the relevant contract by giving the Contractor notice of the dispute. The dispute would then continue through the escalating dispute resolution process until resolved. If the dispute resolution clause is broadly drafted such that the dispute resolution process will apply to “any dispute arising” under the EPC or O&M Contracts, a practical solution may be to have the Contractor consent to the dispute in respect of the PPA being dealt with under the EPC or O&M Contract, as relevant. However, if the dispute resolution clause is more narrowly drafted or if the Contractor’s act or omission cannot be characterised as being a breach of its obligations under the EPC or O&M Contract, it will mean that the act or omission in question could not be the basis of a dispute under the relevant contract. In these instances, resistance by the Contractor to follow the dispute resolution procedure set out in the EPC or O&M Contract may be difficult to challenge. The elephant in the room dispute resolution processes for RE IPP programme introduction PwC 302 Action under the PPA If the dispute with Eskom regarding the Project Company’s alleged breach of the PPA proceeds to the High Court of South Africa, the Project Company could apply to the court pursuant to rule 13 of the Uniform Rules of Court for a joinder of the Contractor as a third party to the proceedings. Joinder of the Contractor is not without its difficulties. Section 6 of the Arbitration Act No. 42 of 1965 provides a party to an arbitral agreement the right to apply for a stay of a third-party notice served under the Uniform Rules of Court, as service of this notice and any purported litigation falls outside of the agreed dispute resolution procedure under the EPC or O&M Contract. If an application for stay was made by the Contractor, the Project Company could raise arguments as to why a stay should not be ordered, such as the futility of the dispute resolution procedure or the risk of multiple proceedings in order to satisfy the court that the dispute should not be determined by arbitration in accordance with the relevant contract. Even if the Contractor is successfully joined and a judgment is entered against the Contractor, as discussed above the Project Company may encounter problems in enforcing the South African judgment in the Contractor’s jurisdiction due to specific rules of recognition of judgments between countries. What steps can parties take to mitigate these issues? Importantly, the Project Company should aim to maintain a strong commercial relationship with the Contractor and Eskom. In addition to allowing disputes to be quickly identified, this should also assist all parties to remain engaged and receptive to practical resolutions discussed in this paper, such as agreeing to joinder or consolidation of claims. EPC and O&M Contracts should also include clauses that provide for consolidation of disputes. Robust contract administration will also assist in order to avoid disputes arising in the first place, or to resolve disputes at an early stage to avoid costs and delays. Given that processes under both the EPC and O&M Contracts and the PPA provide for a stage that involves discussions between the parties’ representatives, it is critical to ensure that the representatives nominated for these discussions have the sufficient decision-making authority allocated to allow them to negotiate and agree on a resolution to the matter. Finally, given that the potential issues outlined in this paper all carry a risk of incurring significant cost and delays, all parties should be aware of these matters as risks to be avoided during the development and operation of the project and of the imperative for cooperation. PwC 303 13 Liquidated damages – Delay and performance Introduction The standard form international contracts designed for use on infrastructure projects (for example, ENAA and FIDIC) differentiate between liability for delay and liability for underperformance of a plant or facility. This paper explains why, from a legal and practical perspective, it is necessary to differentiate between liability for delay liquidated damages and performance liquidated damages as well as different types of performance liquidated damages. Delay liquidated damages The purpose of liquidated damages for delay is to compensate the Project Company for loss and damage suffered as a result of late completion of the plant or facility. In order to be enforceable, delay liquidated damages must be a genuine pre-estimate of the loss or damage that the Project Company will suffer if the plant or facility is not completed by the target completion date. The genuine pre-estimate is determined at the time of entering into the contract. Delay liquidated damages are usually expressed as a rate per day which represents the estimated extra costs incurred (such as extra insurance, supervision fees and financing charges) and losses suffered (revenue forgone) for each day of delay. Performance liquidated damages The purpose of liquidated damages for underperformance is to compensate the Project Company for loss and damage suffered as a result of underperformance of the plant or facility. In order to be enforceable, performance liquidated damages must be a genuine pre-estimate of the loss and damage that the Project Company will suffer over the life of the project if the plant or facility does not achieve the specified performance guarantees. As with delay liquidated damages, the genuine pre-estimate is determined at the time of entering into the contract. The nature of performance liquidated damages means that the measure of liquidated damages will depend on the relevant performance guarantee, for example efficiency, output or availability. Performance liquidated damages are usually a net present value (NPV) calculation of the revenue forgone over the design life of the project. For example, in the case of a power station, if the output of the plant is 5 MW less than the specification the performance liquidated damages are designed to compensate the Project Company for the revenue forgone over the life of the project by being unable to sell that 5 MW. Differentiation between delay and performance liquidated damages The law relating to penalties and uncertainty of liquidated damages regimes is clear. If the amount of liquidated damages is held to constitute a penalty or if the liquidated damages regime is uncertain, it will be held by a court to be invalid. We have seen contracts where delay and performance liquidated damages are combined. This is not recommended as there is a very real risk of a combined liquidated damages regime being struck down as a penalty as it will necessarily include many of the features of performance liquidated damages. This means, from a legal perspective, if there is a combination of delay and performance liquidated damages, the liquidated damages rate must include more of the characteristics of delay liquidated damages if they are to remain a genuine pre-estimate of the Project Company’s losses. If a combined liquidated damages amount includes an NPV or performance element the Contractor will be able to argue that the liquidated damages are not a genuine pre-estimate of loss when liquidated damages are levied for late completion only. The reason for Liquidated damages – Delay and performance PwC 304 this is if the plant or facility is finished late but performs exactly as required the liquidated damages can only legally compensate the Project Company on an extra costs/revenue forgone basis not an NPV basis. However, if the combined liquidated damages calculation takes on more of the characteristics of delay liquidated damages it means the Project Company would not be properly compensated if there is permanent underperformance of the plant or facility. From a practical perspective, the best way of demonstrating why it is necessary to differentiate between delay liquidated damages and performance liquidated damages is to examine situations at both margins, that is, when the plant or facility is 99 percent complete and when it is 95 percent (or less) complete. The examples below assume that the project is being project financed and the Project Company and, more importantly, the Lenders will accept the plant or facility operating at least 95 percent of guaranteed output in preference to terminating the contract and commencing litigation to recover losses. If the plant or facility is 99 percent complete at the date for commercial operation issues of acceptance will arise as the financing agreements will require 100 percent compliance. In order to accept the plant or facility and thereby commence commercial operation and service the debt (which under the financing agreements will take place after commercial operation) the Project Company will have to waive full compliance with the requirements under the contract. The Lenders are likely to approve the waiver because the defective performance will not impact on the project’s ability to service the debt. However, if a single combined liquidated damages calculation is used (which takes on more of the characteristics of delay liquidated damages as described above) it will impact on the return earned by the Sponsors/equity participants. This situation would not arise if there was a differentiation between delay liquidated damages and performance liquidated damages because the project company would be able to accept the plant or facility and recover the NPV of the lost revenue from the Contractor. If the example at the other margin (when it is 95 per cent or less complete) is examined the risks to the Project Company are even greater. If performance of the plant or facility is at only 95 percent and there is no prospect, in the foreseeable future, of increasing that performance the Project Company has relatively few options if a combined liquidated damages calculation is used (which takes on more of the characteristics of delay liquidated damages as described above). Obviously, the Project Company can wait for the performance to be rectified and receive liquidated damages. However, because they are presumably inadequate to fully compensate the Project Company for underperformance, it is likely that the Project Company will default under the financing arrangements which, at a minimum, will trigger additional equity contributions from the Sponsors. It may even lead to the Lenders taking over the project. A better option for the Project Company is to be able to accept the plant and commence operation and recover at least a portion of the forgone revenue as performance liquidated damages. The other alternative is to terminate the contract and sue to recover losses. However, that will be time consuming and expensive and it will not solve the problems under the financing agreements. Differentiation between types of performance liquidated damages The same arguments arise in relation to differentiating between types of performance liquidated damages as apply to differentiating between delay and performance liquidated damages. It is important to differentiate between the different types of performance liquidated damages to protect the Project Company against arguments by the Contractor that the performance liquidated damages constitute a penalty. For example, if a single performance liquidated damages rate is only focused on output and not efficiency, problems and uncertainties will arise if the output guarantee is met but one or more of the efficiency guarantees are not. In these circumstances, the Contractor will argue that the liquidated damages constitute a penalty because the loss the Project Company suffers if the efficiency guarantees are not met are smaller than if the output guarantees are not met. Liquidated damages – Delay and performance PwC 305 Conclusion The prime goal of a Project Company is to receive a plant or facility on time and on budget that operates to specification. The contract should be aimed at achieving that outcome, however the contract should also protect the Project Company when the ideal outcome in relation to performance is not achieved, even where the technology is standard. A contract which differentiates between delay liquidated damages and performance liquidated damages as well as different types of performance liquidated damages achieves an optimal mix between the two outcomes described above, is industry practice and is bankable. Although a single combined liquidated damages calculation may appear simpler, it is legally flawed and will cause significant practical and commercial difficulties. The parties cannot have a single liquidated damages amount which takes into account all the potential permutations and combinations of delay and underperformance as it would not represent a genuine pre-estimate of loss and would be struck down by the courts as a penalty. In addition, a single combined liquidated damages regime is also likely to be held invalid for reasons of uncertainty. PwC 306 14 Offtake and construction interface issues in infrastructure projects Introduction In reviewing the bankability of an infrastructure project, Lenders focus on the offtake agreements to ensure the Project Company will be able to meet its repayment obligations under the financing arrangements. However, the suite of construction-related documents, and primarily the Engineering, Procurement and Construction (EPC) contract for the design, supply, construction and commissioning of the facility for the project (referred to in this paper as the EPC Contract), have a significant ability to impact on the viability and long-term success of a project and are a key area of focus for the Lenders and their lawyers in terms of bankability. If a single EPC Contract structure is not used, it is likely that the issues dealt with below will be more difficult to manage given the increased number of parties and the dilution of each party’s responsibility. This paper focuses on a number of hidden issues that must be considered in a review of the offtake agreement and the EPC Contract, namely:  the access of the EPC Contractor to the grid or system to allow timely completion of construction, commissioning and testing (Grid Access)  interfacing of testing regimes  fuel specification requirements  interface issues between the relevant government agencies and system operator and the EPC Contractor. Not all these issues will be applicable to all projects. Therefore, they will be discussed in the context of a particular project type, eg power, liquefied natural gas (LNG), petrochemical, etc. Importantly, these issues are of equal, if not more, concern to Owners/Sponsors than they are to Lenders. Obligation to provide grid access This issue is of particular relevance to power projects; however, it may also apply, albeit in a different context, to oil and gas, LNG and desalinisation projects, amongst others. EPC Contracts provide for the handover of the facility to the Project Company and the offtake agreement (normally a power purchase agreement (PPA) or tolling agreement in a power context) will become effective once all testing has been successfully completed and certified. This raises the important issue of the EPC Contractor’s Grid Access and the need for the EPC Contract to clearly define the obligations of the Project Company in providing Grid Access. Lenders need to be able to avoid the situation where the Project Company’s obligation to ensure Grid Access is uncertain. Uncertainty may result in protracted disputes with the EPC Contractor concerning the EPC Contractor’s ability to place load onto the grid system (ie as necessary to undertake the commissioning and performance testing required to achieve practical completion) and to obtain extensions of time in situations where the EPC Contractor is delayed as a result of the failure or inability of the Project Company to provide that access. Offtake and construction interface issues in infrastructure projects PwC 307 Grid Access issues primarily arise at two levels:  the obligation to ensure the grid connection infrastructure is in place  the obligation to ensure the EPC Contractor is permitted to export power. Typically the Project Company bears the risk of the obligation to ensure the grid connection infrastructure is in place, since it is usually responsible for procuring the construction of that infrastructure. Issues that need to be considered include:  What physical grid connection infrastructure is to be designed and constructed and how will that infrastructure interface with the EPC Contractor’s works? Are the limits and points of connection clearly defined? Do any of those works have to be designed and constructed by specialist consultants and Contractors accredited by the offtaker or other system operator? Is the construction of these facilities covered by the PPA, concession agreement or any other contract? If so, are the rights and obligations of the Project Company dealt with in a consistent manner (ie to avoid a situation where the EPC Contractor causes the Project Company to be in breach of the PPA or to avoid a situation where the EPC Contractor is entitled to relief such as an extension of time or delays costs where the Project Company does not get corresponding relief under the PPA)?  What is the timing for completion of the grid connection infrastructure – Will it fit in with the project program and the timing under the EPC Contract? Is there a sufficient buffer between the date for completion of the grid connection infrastructure and the target date by which the Project Company must provide the EPC Contractor with access to those facilities? With respect to the EPC Contractor’s ability to export power, the EPC Contract needs to adequately deal with this risk and the parties respective obligations, including:  What is the extent of the Grid Access obligation? Is it merely an obligation to ensure the infrastructure necessary for the export of power is in place or does it involve a guarantee that the grid will take all power the EPC Contractor wishes to produce? Are there restrictions under the PPA in terms of the Project Company’s ability to export power to the grid that need to be reflected in the EPC Contract?  What is the timing for the commencement of this obligation (ie the date for first synchronisation set out in the EPC Contract)? Does the obligation cease at the relevant target date of completion? If not, does its nature change after the date has passed?  What is the obligation of the Project Company to provide Grid Access in cases where the Contractor’s works are late or the plant is unreliable – Is it merely a reasonableness obligation? Is the Project Company obliged to accelerate the completion of the grid connection infrastructure where the EPC Contractor anticipates early completion of its works?  Is the grid (including both the existing infrastructure and the new grid connection infrastructure) robust enough to allow for full testing by the EPC Contractor – for example, the performance of full-load rejection testing?  What is the impact of relevant national grid codes or legislation and their interaction with both the EPC Contract and the PPA? Many EPC Contracts are silent on these matters or pose more questions than they actually answer. However, experience has taught us that Grid Access is a matter which must be resolved at the contract-formation stage and requires input from project management, technical and legal advisors, with experience in the relevant sector and regulatory framework. In addition, given the Project Company’s failure to provide Grid Access will often stem from restrictions imposed on it under the PPA, where it is feasible to do so, it would be prudent for the Project Company to backits obligations under the EPC Contract (usually to provide an extension of time and/or costs) with the PPA. This approach will not eliminate the risk associated with Grid Access issues but will make it more manageable and reduce the contingency/Sponsors support required by Lenders. Offtake and construction interface issues in infrastructure projects PwC 308 Interfacing of the testing regimes This issue is relevant to most types of infrastructure projects, especially power and process plant projects. The testing regime in EPC Contracts must mirror the requirements for testing and commencement under the offtake agreement. Mismatches can result in delays, lost revenue and liability for damages under the offtake agreement, all of which have the potential to reduce returns and cause disputes. Testing requirements under both contracts need to satisfy the Project Company’s requirements under the EPC Contract and the system operator/offtaker requirements under the offtake agreement. Relevant testing issues which need to be considered include:  Are different tests required under the EPC Contract and the offtake agreement? If so, are the differences manageable for the Project Company or likely to cause significant disruption? Can the testing regimes be further streamlined?  Is there consistency between the commissioning, testing and obtaining handover under the EPC Contract and commencement under the offtake agreement? Does the testing regime under the EPC Contract address the requirements of relevant national grid codes? It is imperative to ensure back-to-back testing under the offtake agreement and the EPC Contract, including notice periods and reporting obligations. This will result in smoother progress of the testing and better facilitate all necessary supervision and certification by the Project Company, the independent engineer under the PPA, the offtaker/system operator and/or the relevant authorities. Various certifications will also be required at the Lender level. Lenders do not want the process to be delayed by their own requirements for certification, however, the process may be held up if the Lenders are not satisfied that the facility meets the requirements of all of the various project documents. To avoid delay and disruption, it is important that the Lenders’ engineer is acquainted with the details of the project and, in particular, any potential difficulties with the testing regime and any unique requirements under the relevant national grid codes or legislation. Therefore, potential problems must be identified early and resolved without impacting on testing, handover and operation. Consideration should also be given to streamlining the certification process by engaging a single independent certifier to perform the certifications required under the EPC Contract, the PPA and by the Lenders.  Is the basis of the testing mirrored under both the EPC Contract and the offtake agreement? For example, what basis are various environmental tests to be undertaken? Are they to be undertaken on a “per train” basis or a “plant output” basis?  What measurement methodology is being used? Is the method for certifying plant capacity and the achievement of other performance guarantees specified in the EPC Contract consistent with the PPA? Are uniform testing conditions, correction factors and degradation assumptions applied under the relevant documents? Are references to local and international technical standards or guidelines to a particular edition or version?  Are all tests necessary for the EPC Contractor to complete able to be practically performed given limitations imposed on the facility by third parties, including any restrictions imposed under environmental or other project approvals?  Are the relevant specifications linked to current guidelines such as the World Bank environmental guidelines and has consideration been given to changes that may occur to these guidelines? The EPC Contract represents a snapshot of the standards existing at the date that contract was signed. The actual construction of the facility may occur months or years from that date. Possible mismatches may occur if the guidelines have changed. Accordingly, it is important there is certainty as to which standard applies for both the offtake agreement and the EPC Contract – is it the standard at the time of entering the EPC Contract or is it the standard that applies at the time of testing? Is this issue dealt with uniformly throughout the project documentation? Offtake and construction interface issues in infrastructure projects PwC 309 The above issues raise the significant importance of the testing and performance guarantee schedules in the EPC Contract and the offtake agreement. The complexity, size and importance of various projects, and the impact that the testing and performance guarantee regimes can have on the bankability of a project and the Sponsors’ return of equity, means the days where the technical schedules and specifications were prepared in isolation from the balance of the EPC Contract and other project documentation, and then attached at the last minute without being subject to a combined technical/legal/commercial review, are gone. Fuel specification issues This issue is particularly relevant to power projects, some oil and gas projects, LNG projects and certain process plant projects. It is discussed below in the context of a power project. The nature of the fuel to be supplied to the EPC Contractor is another important issue. Where there is a tolling agreement, as opposed to a PPA, it is vitally important that an adequate review is undertaken at the EPC Contract level to ensure the fuel provided under the tolling agreement meets the requirements of the EPC Contract. In a gas plant or LNG project, if the project relies on gas from a new source, great care should be taken in making any representations under the EPC Contract as to the gas specification, which should be backto-back with the specification in the tolling agreement or other fuel supply agreement. Differing fuel specification requirements will result in cost claims and extension of time claims at the EPC Contract level. They can also impact on the EPC Contractor’s ability to achieve the plant output performance guarantees and enable the EPC contactor to avoid paying corresponding performance liquidated damages that underpin the bankability of the EPC Contract. Fuel specification issues may be hidden away in the technical schedules and specifications. Accordingly, the technical schedules and specifications must be reviewed before being incorporated into the EPC Contract to ensure the fuel specification issues are dealt with appropriately. In addition, where certain tests require specific types or quality of fuel, the review should confirm that arrangements are in place for that type of quality of fuel to be provided at the agreed times set out in the EPC Contract, eg high sulphur coal may be required to properly test flue gas desulphurisation equipment. Day-to-day interface between the offtaker and the EPC Contractor At a fundamental level, it is imperative the appropriate party corresponds with the relevant offtaker/system operator during construction on issues such as the provision of transmission facilities/fuel requirements/testing requirements and timing. Whilst the EPC Contractor must be obliged to coordinate and interface its works with the offtaker/system Operator, the Project Company will need to ensure that the EPC Contract provides sufficient certainty that it, rather than the EPC Contractor, is the appropriate party to correspond with the offtaker/system operator. Otherwise the EPC Contractor may deal directly with the offtaker/system operator. The Project Company will always want to develop and nurture an ongoing and long-term relationship with the offtaker and ensure the EPC Contractor does not cause the Project Company to be in breach of the PPA. On the other hand, it is the EPC Contractor’s prime objective to complete the project on time or earlier to maximise its profit. In many cases, the clash of these conflicting objectives does not allow for a smooth process. Again, the resolution of these issues and clear articulation of the parties’ corresponding rights and obligations at the EPC Contract formation stage is imperative. Conclusion The above review provides a snapshot of various issues we have dealt with on a variety of infrastructure projects in the region. The failure of the Project Company and EPC Contractor to deal with these issues with certainty at the contract formation stage will only, in our experience, result in delay, cost, lost revenue and disputes. Accordingly, these issues must be recognised and dealt with appropriately in the project documentation. PwC 310 15 Operating and maintenance agreements – Key issues Introduction The Operating and Maintenance Agreement (Agreement) supporting an infrastructure project has a significant impact on the projects’ long-term success. Accordingly, it is a key document from both the point of view of the Owner and the Lenders in reviewing the bankability of a project-financed project. The purpose of this paper is to highlight the key issues in a draft Agreement that must be addressed. Not all these issues will be applicable to all projects. However, this “checklist” will be useful in identifying areas of the Agreement that may require further attention. This paper assumes the Operator is not one of the project Sponsors and has a true “arms-length” relationship with the construction Contractor. If that is not the case there will be a range of additional issues to consider, especially for the Lenders in a project-financed project. Some of these issues are considered briefly at the end of this paper. Pre-operational phase Key issues to consider in relation to the pre-operational phase are:  Does the Operator have a contractual role on the project before the handover of the facility by the Owner? In particular, does the Owner require the Operator to advise, prior to acceptance testing of the facility, on matters such as the necessary staffing levels, work programmes, organisational matters and other administrative functions that must be put in place upon acceptance and handover of the facility to the Operator?  Does the Agreement set out the testing, commissioning and handover procedures, particularly having regard to the transfer of responsibility for the care of the facility from the construction Contractor to the Owner and/or Operator? Are these procedures back-to-back with the construction contract? Is there more than one construction contract or a number of different work packages with varying completion and handover dates? An issue likely to arise in the negotiations will be the degree to which the Operator will be responsible during the period when the Operator’s staff are in control of the facility but under the supervision of the construction Contractor – eg during the acceptance testing phase but prior to handover. Usually, as a matter of contract, the construction Contractor remains responsible for the facility until handover. However, acceptance, commissioning and performance testing will normally be carried out by operations personnel. In these circumstances, the Operator is unlikely to agree to be liable. Therefore, there must be a clear statement in the construction contract that the construction Contractor remains liable until handover, regardless of whose personnel are physically conducting the testing. Where there are a number of construction contracts for different components of the project with varying completion dates (for example, mining or hospital projects delivered under an Engineering, Procurement and Construction Management (EPCM) or construction management model with a number of separate work packages), the Owner needs to consider the extent to which the construction Contractors, the Owner and/or Operator will be responsible for care of the works during the period from when the first work package is completed and ready to be handed over, to the date of handover of the entire project to the Operator. Ideally, from the Owner’s and Lenders’ perspective, the individual construction Contractors will remain liable for their scope of works until handover of the entire project. However, this may not be feasible depending on the nature of the project and the stage in the construction program, particularly as the Contractors will want to achieve handover as early as possible under fixed lump sum contracts to reduce their overheads and increase profit. In these circumstances the Contractor is unlikely to agree to be liable and to minimise gaps in liability, Lenders may require the Operator (rather than the Owner) to accept responsibility on completion of the individual work packages. Accordingly, there must be a clear statement in the Agreement that the Operator is Operating and maintenance agreements – Key issues PwC 311 responsible during the interim period and must have the necessary resources available to perform those obligations from the time of handover of each work package. Operation of the facility The substantive contractual obligation of the Operator is to operate and maintain the facility for the period specified in the Agreement. A key issue is whether the responsibilities of the Operator during this period are set out in sufficient detail. The Agreement will need to cover matters such as:  operating procedures  maintenance of the facility (including major overhauls and scheduled/unscheduled outages)  responsibility for procurement and maintenance of a spare parts inventory  performance levels and performance guarantees to be met by the Operator  interface with the construction Contractor(s) prior to handover and during the defects liability period  interface with other Owners’ operations team (for example, where the Owner elects to undertake certain site-related services in respect of the operation of the facility) and the potential impact on the Operators performance guarantees  owner’s option to extend the term  reporting requirements to the Owner, Lenders and perhaps to the government authorities  maintenance of the continuing contractual relationship with the government authorities (if relevant) and utility suppliers on behalf of the Owner  compliance with operational requirements imposed under the regulatory regime (for example, compliance with environmental controls and local Ownership and industry participation requirements imposed on the project) and other project documents. The description of the Operator’s obligations is often complex and requires significant project management and technical expertise relevant to the project type and technology. This can, to some extent, be simplified by attempting to describe the general requirements of the Operator and relating those obligations to the performance results required to be achieved out of the operation of the facility, including all matters necessary and incidental to that performance. However, there are arguments against this approach, particularly if it is relatively simple for the Operator to claim additional payments under the agreed compensation regime. Therefore, care should be taken in electing this simplified drafting approach and advice should first be sought from appropriately qualified and experienced technical advisors. Finally, having regard to the long-term nature of operation and maintenance agreements, the p